Read This Before Shorting Anything!

by: Raman Bhalla
Summary

Shorting mechanics are a bit more complicated than just betting on a price decrease of a specific security.

Short sellers should be aware they are responsible for all payments from that security.

If you want to be a holder of record, make sure you aren't lending out your security.

Shorting stocks has the potential of unlimited losses unlike shorting bonds.

There are some tactics to shorting and securities lending that may be helpful to know.

Shorting is a helpful investment method to protect any portfolio from market downturns or to even take a view on an individual company but it's something that's a bit more complicated than just betting on a security's price decline that investors should be aware of before trading. Here's a look into it a big further.

The basics:

Short selling is betting on a price decline of a specific security whether it be a stock or bond.

If a person cares to short a stock or bond, he or she will need to borrow the security from a lender, give them an IOU, and sell the security in the market. No person would lend out their securities for free, so the short seller needs to compensate the lender for lending them their securities by paying them a fee (borrow rate). The lender lends their securities, gets an IOU from the lendee to return it to them eventually, and receives a fee for allowing the lendee to borrow them.

Just conceptually, if I was a lender who wasn't getting paid for lending out my securities to a short seller, I am essentially letting a person bet against a security that I'm long for free which is obviously a conflict in investment interests.

This fee is determined by the liquidity of the securities lending pool (which is different than the liquidity of the security) and the demand to short those securities. Usually a prime broker will tell you the securities lending availability by checking their "feeds" which tells them different advertisements of size and fees being offered from different sources around the Street.

The difference between the liquidity of the security versus the liquidity of the security lending pool is that not all securities are available to be lent out for a myriad of reasons. One cannot judge a security's borrow availability by how much it trades in the markets.

You can think of what the fee will be by supply and demand rationale. If there are a lot of securities available to be lent out, then the fee is low, as you can borrow the securities from a lot of available sources, which creates competition to have the lowest fee (large supply, low demand). If there is a small amount of securities in the lending market and a lot of short sellers wanting those securities, then the fee will be high (small supply, high demand).

One needs to borrow the securities before short selling to prevent "naked short selling," meaning you don't have the underlying securities to sell. This prevents artificial securities from entering the market and also if a short seller sells me a security without borrowing it, what do I own then? This obviously creates chaos and could cause wild market swings (if I had unlimited capital and could naked short sell, I could just keep selling until I clear out all the bids and depress the security to unjustifiable levels).

Let's explore a bit further:

I want to short a stock. I borrow it from person A, give them an IOU, and pay a small fee to them in order to compensate them for lending me the stock. I then sell the stock in the market to person B.

Now the stock unexpectedly has a vote and all the holders of record can submit their elections. Who is the holder of record? Who is entitled to vote? Person A or person B? Well the answer is person B. I sold the stock I borrowed from person A to them. The stock settled in person B's name.

Now let's say the stock pays a dividend. Who gets the dividend payment? Person A or person B? Well person B does from the company, but me, as the short seller, needs to compensate person A for that company dividend and pay it to them.

If you need to be the holder of record, make sure your stock isn't being lent out by your broker. This typically isn't the case unless you bought the stock on margin. If that is the case, typically you can move your stock into a fully paid cash account in order to be the recorded holder.

Always remember, if you are a short seller, you are responsible for all payments and/or coupons/dividends from the security to the original holder you borrowed it from.

An example of this, I borrowed a stock from person A for a fee of 1% per year. I short sell this stock to person B in the market at a price of $100. Over the course of the year, the stock paid a $4 dividend and dropped to a price of $95. I decide to close out my position. I buy the stock and deliver it to person A covering my short position and canceling my IOU. It may look like I made $5 because of the difference in price from where I shorted it to where I covered it, but I had to pay a $4 dividend to person A (the $4 dividend was paid to person B from the company) and also pay them a 1% annual fee, which equated to $1 over the course of the year. So I made ($100 - $95) - $4 dividend - $1 fee which equals $0.

Also, a little bit more complicated is that you may earn money by borrowing a security by getting a "rebate." Basically, the money you earn on your short sale proceeds (the money you take in from short selling the security) is greater than the fee you need to pay to borrow the security. But for the most part, investors should figure they need to pay a fee to borrow a security.

Even further:

The short seller is responsible for the borrow fee and any payments the security may pay out including dividends and coupons.

Most short sellers are wary about short selling a stock with a regular high dividend unless they are confident the dividend will be cut or suspended. If the dividend is cut, that infers the dividend yield is less and the stock price will drop to compensate.

The same idea applies to bonds. The short seller has to pay the interest coupon to the person that lent them the bond. The person who bought the bond from the short seller is the holder of record and receives the coupon from the company.

Risks:

Now the risks involved with shorting is something everyone should be aware of. Shorting stocks isn't for the tepid because unlike being long a stock, your losses aren't limited.

For example, I bought a company's stock at $10 (I'm long). The most I could lose is -$10 if the company goes bankrupt and goes to $0. So if you are long anything, your ultimate loss is the security ends up worthless and you lose all your invested money. There isn't a case where the security will have negative value and you will end up owing money. So your risk is capped to a certain point.

But with shorting a stock, this is not the case. Your losses are potentially uncapped. For example, I shorted that same stock at $10. The stock then doubles and I lost -$10. The stock triples and I now end up losing -$20. The stock then rallies to $100 and I now lost -$90. The upper bound of where a stock can go is uncapped. There's no end limit to where a stock can appreciate. Obviously, one can assume a stock bound won't be infinity because investors would realize it's trading at insane multiples and would start to sell, but there is no cap to losses like you have being long a stock. Investors can lose more money than they put in.

But unlike shorting stocks, there is a cap to losses when shorting bonds. To oversimplify, if I'm short a bond at $99, the most I can lose minus whatever I need to pay for coupons and borrow fees is $1 when the bond goes to par when it matures. Obviously, there are cases where the bond trades above par depending on rates and yields but for simplistic sake, a bond cannot mature above par so that caps a short seller's losses to a point.

Stocks vs. Bonds:

As shown above, one might prefer shorting bonds over stocks because you are capped to how much you can lose when shorting a bond that you don't have when shorting a stock. I certainly feel more comfortable with the cap to how much I could potentially lose. But with that said, you really have to be comfortable with the deteriorating credit quality of a company or sovereign to short a bond. As stated in another article, credit gets paid before the equity holders and is less likely to be impaired due to the capital structure. So if there is real financial trouble, the stock will drop before the credit is feared to be impaired. And if the credit is going to be impaired, the stock is most likely 0.

If you want to short a stock but don't want to have your losses uncapped, then there is always put options, which will do that for you. You are short at a certain price and only risk the premium you paid to buy the put option.

What else could go wrong while shorting?

Most of the time, just because you borrowed a security from a lender and gave them an IOU doesn't mean they can't ask for that security back at any time they please unless you two entered into a term borrow agreement (agreement to borrow the security for a specific amount of time without the risk of being called back from the lender but since the lender is locked in to letting the short seller borrow the security for a specific amount of time they ask for a higher fee) which isn't common in the lending markets but I have used them before. So if the lender wants the security back and you aren't ready to cover your short, you have 2 options:

  1. Find another lender willing to lend you the securities and deliver it to the first person wanting their securities back and now be short with the new lender.
  2. Buy the security in the market to close out your short position prematurely and deliver it back to the lender.

If all the lenders at the same time request their securities back, this can cause a "short squeeze," where all the short sellers have to buy the securities back in the market to cover their short positions artificially inflating the security's price. Sometimes a large holder of the stock will move their position from a margin account to a cash account in order to cause this (there's no rule saying you have to lend out your stock if you are a large holder but is generally frowned upon when it causes a wild stock fluctuation).

There are other tactics people use when trying to secure borrow, one I mentioned here which can cause a real short seller to show up as a top long holder from their filings. The holder is both long and short the stock to create a riskless "box" position. They sell the long part of the box when the stock appreciates to the price they want to be short at making the holder essentially get short at that level. This just ensures that the short seller has the borrow for hard lending names when they want it and don't need to find a locate when the stock gets to the level they want to be short at. The filings only show their long position (not their net long and short combined positions) which will make them show up as a top holder of the stock implying they have a long thesis, which they might not have. Long story short, don't always believe 13-f filings.

Conclusion:

It's true, over the long run, the stock market appreciates. But if you listen to Warren Buffett:

"Rule Number 1: Never lose money. Rule Number 2: Never forget rule Number 1."

Then you've got to use shorting to protect capital during any downturns, periods of volatility, or to hedge your positions, but there are inherent costs and risks associated with it that not all investors are aware of. A balanced portfolio should have a little short percentage to either hedge current positions or to just protect from market fluctuations. Some people are inherently against shorting because you are betting against companies, but shorting does have its advantages. It increases stock market liquidity and can weed out some bad companies and/or outright frauds if used in the idealistic fashion and not just for short-term profits.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.