What Is Shorting a Stock: Risks, Utilization, & Cost to Borrow


What is shorting a stock? / Short selling?

It is called short selling when you sell a financial instrument (usually a share) that you do not own from the beginning. It is called shining, or “lying short”. The purpose is to be able to make money on a stock even if the price drops. Normally, you buy a share because you think that the price will rise over time, but short selling is the opposite because you then hope that the price will fall.

How does short selling work?

To make money on a falling stock price, you simply borrow shares that you do not own on the market by taking up a short position.

Then they sell the shares and hope to be able to buy them back cheaper in the future. The blanker has, because he or she has borrowed the shares from someone, a requirement to return the borrowed shares at some point in the future.

If the price at which you buy back the shares (including fees) is lower than the price you initially sold them for, you have made a profit when you return the borrowed shares.

The profit is thus the difference between the selling price and the repurchase price.

Example of how short selling works:

Jenny believes that Investment Inc’s share price will decrease. She wants to make money from this, which she can do by shorting the share.

When she borrows the shares, they cost $10 / each, for which she also sells them.

Quite rightly, the share drops in value shortly thereafter. When the share is worth $8, Jenny decides to settle for the profit she has made on the deal.

Since the share is borrowed, she must return the same number of shares that she borrowed from the beginning.

When she sold the borrowed shares on the market, she received $10 and when she bought back the shares to return them, she only paid $8.

The difference between the sales price ($10) and the repurchase price ($8) was her profit.

In this case, the profit was $2 or 20%.

How do you actually short sell?

In order to be able to short, you must first and foremost examine which agreements you need to send in to your bank / broker.

The framework agreement is standardized and deals with the obligations that exist between the broker and the lender of shares.

With Robinhood for example and with many other players, you also have to send in a credit agreement to be able to short.

This is because you risk ending up in a negative position if the short selling goes in the wrong direction, which means that you may owe money to the institution / bank.

The shorting transaction itself is easy to complete.

You search for the share you want to short sell and place a sell order for more shares than you have in the account.

After the sale, you get a minus in front of the holding on your account overview. When you then want to cover the position, ie close the short sale, you buy back the same number (or more if you want) in the same account just like a regular share purchase.

All administrative matters with share loans, such as the delivery of dividends and subscription rights, are handled by the broker / bank.

Note, however, that:

  • Not all shares can be shorted, but with your broker you should find an overview of which shares can be shorted
  • An agreement is required to have the opportunity to shine. The agreement for blank is standardized and deals with the obligations that exist between the blanker and the person who lends shares
  • There are usually both administration costs and interest costs for short selling. This means that short selling is generally not suitable for small businesses or for small savers

Ownership is transferred in the event of short selling

When a share is lent, the ownership passes to the seller and then on to the person who bought shares from the seller.

This means that those who lend their shares, for example, lose their voting rights until the shares are returned.

However, the lender has a right of claim on the shorter, which means that he or she can withdraw his or her shares from the shorter at any time, who is then forced to buy them back.

If the company also pays a dividend during the shortening period, the marker must pay the dividend to the person who lent the shares, and if the company makes a new issue, the marker must deliver subscription rights to the lender as soon as they are available.

Should the company be acquired or go bankrupt, the share loan will cease to apply.

illegitimate / naked shorting

What I have gone through above are examples of what is called a genuine short selling.

However, short selling can also be spurious, or “naked” as it is also called. An illicit short sale means that you sell shares that you do not own without taking out a share loan.

False short selling is generally not permitted in most places, but may be okay in some cases when you first succeed in locating the share and ensuring that you can fulfill your delivery obligations.

This means that you must be sure in advance that the shares you are short of are really available to borrow if you do not buy back the shares at the end of the day.

If you fail to do so, the short sale is therefore spurious, and thus impermissible.

Safety requirements for short selling

In the event of short-selling, the short-term borrower is charged with a so-called security requirement to cover the share loan.

This safety requirement is normally around 130% of the value of the short position.

When you sell borrowed shares, you receive the sales proceeds in the account. If the security requirement is 130%, this means that you must have cash or credit space of at least 30% in addition to the payment that comes in to be able to execute the order.

If you do not have enough collateral, you will be denied the transaction.

The collateral requirement is to protect all parties to the transaction, ie the bank / broker, the broker and the lender of the shares.

This is important in order to be able to react in time and close positions where there are no longer sufficient funds to bear the risk of the short sale or shortcomings that have been made.

Example

Lukas wants to short for $1000 in the Ericsson B share, which is traded for $1 / share. He has no Ericsson before in his account and therefore sells 1000 shares at $1 / each.

Lukas has now taken a short position and is minus 1000 Ericsson B in his account.

In connection with the transaction, he has received $1000 in his account for the borrowed and sold Ericsson B shares.

His safety requirements are calculated automatically and in this case it is 130% of the short position.

This means that $1300 is reserved in his account in connection with the short sale and he therefore needed to have $300 in his account in order to be able to complete the short sale at all when he pressed the sell button and sold the 1000 Ericsson B shares.

With some brokers, it works so that the systems calculate the security requirement in real time according to the latest payment in each share that you have chosen to clear.

This means that if Ericsson B were to trade in $2 / share, Lukas’ security requirement will instead be 2 * 1000 * 130% = $2600.

Since he makes a loss on his short selling if Ericsson B goes up, the security requirement will be higher.

In other words, more money will be required to close Lukas’ short sale at $2 than he received at the sale of $1.

What does it cost to short?

That shorted shares are associated with three costs:

  • Brokerage for the deal when buying and selling – just like when you sell and buy in normal cases
  • An administrative fee for the short sale
  • Borrowing rate for the shares you borrow

The risks of short selling

Like any type of investment in the stock market, shorting shares always involves a risk. The risk is that you need to pay a higher price to return the share than you borrowed to buy it from the beginning.

However, a share can only decrease in value by 100%, while it can increase in value as much as you like. If you look at it that way, then maybe short selling is not so stupid after all?

Things can happen on the stock exchange that can lead to unexpected price increases such as bids for a company.

It is therefore important to be aware of what can happen if different situations arise.

It is also important to know that the person from whom you borrowed shares can recall them at any time.

This will mean that you have to close your position.

Conclusion

Why does someone lend shares?

In order for you to be able to short, there must be someone who is willing to lend shares.

It is therefore only possible to short the shares on which there are available loans.

The lender of shares can always request these back. There is thus a risk that you need to close your short position earlier than you planned.

Usually it is large fund companies or pension funds that lend the shares for short selling. The lender earns an interest on the investment.

You who take the share loan and short pay an interest and any administration fee while you have a short position in your account.

You who are shorting need to keep a security requirement in your account.

This ensures that you can pay if the position is moving in the wrong direction. Both the balance and any loan value that you have in the account can be used as security requirements.

If you still feel unsure about the topic then check out this really well-made video on everything you need to know about how this works:

Sources

https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.2007.01269.x

https://www.sciencedirect.com/science/article/abs/pii/S0378426607002397

https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6288.2011.00319.x

https://www.nber.org/papers/w20282

https://academic.oup.com/rfs/article-abstract/26/6/1363/1595651

http://eng.pbcsf.tsinghua.edu.cn/Upload/file/20170111/20170111151156_9872.pdf

https://www.sciencedirect.com/science/article/abs/pii/S0304405X16300824

https://www.sciencedirect.com/science/article/abs/pii/S0304405X02002246

https://www.haas.berkeley.edu/wp-content/uploads/shortliq.pdf

https://academic.oup.com/rfs/article-abstract/30/3/801/2682978

Kevin

This article has been reviewed by our editorial board and has been approved for publication in accordance with our editorial policies.

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