Shorting query

[avinalarf]

I've read up on it but I'm still unsure of how it works.
1) How do you find someone to loan you the shares ?
2) Do you have to name a date when the transaction expires ?
3) if the shares rise what happens.
I know the shorter will lose money but where does the loss go to ?
4) I understand that the owner of the shares will get a small % from the shorter so how is the % calculated ?
5) Apart from the % the owner gets what's in it for him ?
6) So a share is shorted , it's loaned at £4 a share and drops to £2 a share how does the shorter realise his gain ?

[P.Griffin]

Most short selling the retail public will be exposed to will be via CFDs. These are basically bets between a buyer and a seller on an asset's value...there is no physical exchange of the asset between them.
The scenario you are talking about usually takes place at investment bank and hedgefund level. Assume you are the short seller, you find a buyer but you need to borrow what you do not have to sell...in comes the stock lender. If the price drops, you make money from the guy who bought and visa versa and the lender gets paid a % age for lending his stock.
Different stocks will have different percentages for lending (market driven) and the length of loan can be agreed beforehand also but is usually up to 1 year and the owner can call them back as he/she wishes.

Edited by P.Griffin on Wednesday 21st August 17:46

Edited by P.Griffin on Wednesday 21st August 17:49

[Condi]

avinalarf said:

I've read up on it but I'm still unsure of how it works.
1) How do you find someone to loan you the shares ?
2) Do you have to name a date when the transaction expires ?
3) if the shares rise what happens.
I know the shorter will lose money but where does the loss go to ?
4) I understand that the owner of the shares will get a small % from the shorter so how is the % calculated ?
5) Apart from the % the owner gets what's in it for him ?
6) So a share is shorted , it's loaned at £4 a share and drops to £2 a share how does the shorter realise his gain ?

3)) The money moves to and from the market. If the shares rise, the shorter will have to buy them back at more money; so has lost because he called the market wrong (ie sold at £4, has to rebuy at £6) but also because he is paying a fee to the share owner all the time it is lent out.

4)) The owner of the shares gets paid a fee, which is priced as a market on its own; IE if loads of people want to short the stock, you will pay a lot because a) the market obviously thinks the share price has a good chance of going down, and you want to borrow from someone who is long, and b) because of those who are long only a number will want to lend their shares, and so lots of short sellers are competing for a small-ish pool of lenders. Inversely the same is true if there are few people wanting to short a share, and lots of long holders willing to lend them out.

5)) Aside from the fee, not much for the long holder. Obviously if the price goes up, they have a more valuable asset. But also people like pension funds, market trackers etc almost have to own the shares, and would have little or no reason to sell them in the short to medium term. By getting a fee they are simply making more of the asset they already own, and will continue to own.

6)) The gain is simply realised by buying something at £2 and selling it at £4; except you're doing it backwards. You're selling it first, then buying it back cheaper. The money moves to and from 'the market'; you have no idea who is buying it when you short it, or who is selling it when you buy it back.

[avinalarf]

Thank you both for your replies that have helped me understand the mechanics.

[DonkeyApple]

avinalarf said:

I've read up on it but I'm still unsure of how it works.
1) How do you find someone to loan you the shares ?
2) Do you have to name a date when the transaction expires ?
3) if the shares rise what happens.
I know the shorter will lose money but where does the loss go to ?
4) I understand that the owner of the shares will get a small % from the shorter so how is the % calculated ?
5) Apart from the % the owner gets what's in it for him ?
6) So a share is shorted , it's loaned at £4 a share and drops to £2 a share how does the shorter realise his gain ?

5) of you are holding long then you have a belief that over the time horizon that you are targeting the price will rise. As such, those who think it will fall fall into two camps, the first being those with the same time horizon as you and so are wrong in their view so you might as well take some income off them, the second being those with a different time horizon so if they are right or wrong it doesn’t matter to you as you know you’ll have fluctuations so you might as well take an income off them. There’s also the hedging aspect which is someone who is king like you but his balls are a little smaller so he needs to hedge some of his risk by selling a part short and you might as well take an income off him also.

Generally, if you’re a fund sitting on long term holdings then you’ll permit your custodian to put your stock out as available to lend and you will factor the income potential into your overall model.

1) You don’t have to go looking. The global custodians all lend out client stock for income and there is a whole market running this side.

[avinalarf]

Thank you Donkey.
So for clarication.......shorting is usually conducted by an investment bank and a hedge fund .
The investment bank loans the shares to a hedge fund for a commission , the commission is commensurate with the amount of interest displayed by the market .
If a private investor wants to indulge in shorting he will do it via a CFD.
I presume if a private investor had several millions to speculate he would be able to go short via his broker, I presume he would need a broker to do this .
Otherwise I presume he might go on a platform like HL and use a CFD , is that correct ?
So in the case of Aston Martin as an example ........
If you had wanted to short their shares and borrowed 1 million shares soon after the IPO at say £18 a share and they now stood at £5 you would have made a profit of £13 a share , i.e. £13 million less the commission.
How then does the hedge fund return the borrowed I million shares to the investment bank whilst realising that £13 million profit ?
Sorry to be so thick about this.

Edited by avinalarf on Thursday 22 August 05:25

[98elise]

Many years ago (if memory serves) when I first started trading there were settlement periods where you could buy and sell within a set period (2 weeks IIRC). At the end of then period you then settled up what ever you owed.

This meant not only could you buy and sell in the period and not need to pay for the shares, you could also short within the same period.

I hope I've remembered that correctly!

[omniflow]

avinalarf said:

How then does the hedge fund return the borrowed I million shares to the investment bank whilst realising that £13 million profit ?
Sorry to be so thick about this.

Edited by avinalarf on Thursday 22 August 05:25

It buys them @ £5 each (£5million total) using some of the £18million is has from selling them earlier @ £18 each.

[DonkeyApple]

avinalarf said:

Thank you Donkey.
So for clarication.......shorting is usually conducted by an investment bank and a hedge fund .
The investment bank loans the shares to a hedge fund for a commission , the commission is commensurate with the amount of interest displayed by the market .
If a private investor wants to indulge in shorting he will do it via a CFD.
I presume if a private investor had several millions to speculate he would be able to go short via his broker, I presume he would need a broker to do this .
Otherwise I presume he might go on a platform like HL and use a CFD , is that correct ?
So in the case of Aston Martin as an example ........
If you had wanted to short their shares and borrowed 1 million shares soon after the IPO at say £18 a share and they now stood at £5 you would have made a profit of £13 a share , i.e. £13 million less the commission.
How then does the hedge fund return the borrowed I million shares to the investment bank whilst realising that £13 million profit ?
Sorry to be so thick about this.

Edited by avinalarf on Thursday 22 August 05:25

Pretty much. So all funds usually employ a custodian to look after their assets, such as Bank of NY, State Street etc. It’s those custodians that then put stock out to lend generally speaking. (A little interesting aside is that when Musk was complaining about short sellers, he was one of the biggest suppliers of lend due to his debt deals with the likes of Morgan Stanley which saw him lodging TSLA stock with them as collateral for around $500mnof loans).

As for which brokers you can do this with, if you’re using a large corporate brokerage then you will have this facility but it’s really never been cost effective for retail brokers to offer it. Very few retail clients go short and the OTC industry is a much cheaper and efficient means to do so anyway.

How retail brokers have tended to offer some form of service in the past is via extended settlement agreements with a market maker. This doesn’t involve any stock lending but instead the market maker who takes the sale will agree that the settlement of the transaction can be delayed, 10,15 ,20 trading days. They will charge the client a wider price on the execution as their fee. That makes it an extremely expensive way to short.

Whether corporate or retail almost all short positions are created using the CFd mechanism as it is highly efficient.

In the case of a retail broker there usually isn’t actually any stock lend involved. Retail clients who short a stock are very usually looking to short something that all the other clients are heavily long of so the ‘lend’ in this case is supplied by the long side clients.

You only tend to naturally need to hedge the short trade with the clearer if it’s an unusual stock, a small or mid cap that isn’t being bought up by the retail market. And ironically, this tends to be a suspicious trade anyway and investigation often shows up that the client is the FD of the company with inside information or some other kind of connected party to either the company, its accountants or one of the penny share journalist. So the trade is fully hedged with physical and then reported along with the account to the regulator.

As for how you return the stock, you just buy back the required amount in the open market and send it over to the Custodian who settles it against what you borrowed. It’s not the same stock. When you sell short in the first instance, on the other side is a buyer who wants what he just bought delivered to him. You have nothing to deliver despite placing a sell order as if you did. So you borrow a load of stock from a custodian and they charge you interest based on the value. You take that borrowed stock and send it over to the purchaser and the trade is settled. When you come to to want to close your short then you have to return the stock that you borrowed to the custodian but you don’t have any stock so you have to go into the open market and buy what you need and then you send that stock over to the custodian and they end your borrowing arrangement.

It’s all done electronically. In the old days you had to match the trade numbers manually and it was all very slow.

[DoubleSix]

98elise said:

Many years ago (if memory serves) when I first started trading there were settlement periods where you could buy and sell within a set period (2 weeks IIRC). At the end of then period you then settled up what ever you owed.

This meant not only could you buy and sell in the period and not need to pay for the shares, you could also short within the same period.

I hope I've remembered that correctly!

Yeah, you can use the settlement dates in this way; T+3, T+10, T+20 etc

Back when I was on the equity desk as a young and reckless lad we would often place sell orders for stock we didn’t own on T20, perhaps ahead of a trading update. Then if the stock bombed on the day you enter a buy order with a matching settlement date to net off the ‘short’.

Great way of boosting the month end or just losing your wages before you’ve even seen them... ahh what larks we had!!

[DonkeyApple]

DoubleSix said:

Yeah, you can use the settlement dates in this way; T+3, T+10, T+20 etc

Back when I was on the equity desk as a young and reckless lad we would often place sell orders for stock we didn’t own on T20, perhaps ahead of a trading update. Then if the stock bombed on the day you enter a buy order with a matching settlement date to net off the ‘short’.

Great way of boosting the month end or just losing your wages before you’ve even seen them... ahh what larks we had!!

With the added bonus that so long as the dealer liked you you got their execution rate at the market makers so you still paid best.

[DoubleSix]

[avinalarf]

Finally got it.
Thank you all for your help as its been bugging me for a while as to how it works .
It's horses for courses I suppose, I beat myself up over this but you can't know everything about everything.

[avinalarf]

Oops ......one last thing.
Why would you lend someone shares to short the shares and then see the shares that you the lender own fall in value ?
Surely if you own shares you want to see them rise not fall and not facilitate someone who wants them to fall in value.
Apart from a commission the lender doesn't appear to be working in his own interest.

[DonkeyApple]

avinalarf said:

Oops ......one last thing.
Why would you lend someone shares to short the shares and then see the shares that you the lender own fall in value ?
Surely if you own shares you want to see them rise not fall and not facilitate someone who wants them to fall in value.
Apart from a commission the lender doesn't appear to be working in his own interest.

Because the person you’re lending to is wrong in their view so it’s an opportunity to take some money from them. If you thought they were right in their view that the stock was going to fall then you wouldn’t be long.

But in reality, most hedges aren’t bets that the price is going to fall long term but in the short term whereas most long positions that will be lending will be long term positions with a long term view so as a long term investor you know that there will be ups and downs along the way and lending your stock out is a means to generate an additional income.

The best way to think about this is from the perspective of say a Warren Buffet long term investment in a blue chip quality company and not from thebmore common retail perspective of a junk smallcap. In the former the Buffets don’t care about short term movements, the traders and those looking to hedge out risk for a moment in time have short term investment horizons and lending them your stock has zero impact on the underlying share price. Indeed, most short holdings are hedges taken out by long term investors.

The issue is that the media only ever talks about shorting when it is happening in a distressed market and then the retail investors get the mindset that their stock value is falling because others are shorting it. But that’s an erroneous perspective. The reality is that the price is falling because not enough investors have the same view as you and so there isn’t enough demand to keep the price up.

In the retail space around small caps it’s an uncomfortable truth that the shorters tend to be the group that have done proper research and have a proper understanding of the business whereas in the long side it tends to mostly be gamblers who have just jumped on a punters bandwagon because of a pump by a journalist or bulletin board hero.

Just to throw another little spanner in, if you’re short a stock then you don’t want to still be holding if the price goes to zero or the stock is suspended because you can’t then buy backnon the open market and instead have to find a stock holder yourself and strike a deal at a price at which they will sell to you off exchange.

[anonymous-user]

Derivatives of any kind can be used either to balance a position or for flat-out gambling.

Shorting is high risk territory for a private investor IMO.

[avinalarf]

Thank you Donkey for the trouble you've taken to educate me.
Thanks to all the other contributors.

[DonkeyApple]

rockin said:

Derivatives of any kind can be used either to balance a position or for flat-out gambling.

Shorting is high risk territory for a private investor IMO.

I tend to agree. The irony being though that the typical retail shorter tends to make much more money than the typical long only trader on the equity side (doesn’t hold for indices/fx). I suspect that is because being a shorter tends to be more lonely and takes a lot more thought.