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Ask HN: Please explain short selling?
95 points by captaincrunch on June 14, 2010 | hide | past | web | favorite | 100 comments
So I just wrote a stock prediction system... I understand just enough about the market to be dangerous. One thing I simply cannot wrap me head around is selling short. Who are the stocks borrowed from? Are the people lending the shares actually hoping for the stocks success?



1. You borrow 100 shares from a broker.

2. You sell the 100 shares for, say, £1000 in total.

3. Prices for the share ideally go down. (You and others have been selling, after all)

4. You then buy 100 of the shares for, say, £900 in total

5. You then give the broker the 100 shares back

6. You've made £100

Normally the broker would charge a commission for the lending, hence his/her motivation. So if the commission were £10 you'd have £90 profit.

Naked short selling is when you miss out the broker. So you don't owe the broker anything, but you still need to give the buyer of your fictional shares something real, so you end up buying them, at a hopefully lower price, later.

Defenders of short-selling claim it helps quickly respon to fundamentals in the market place. For instance once we heard the US might fine BP people could start selling BPs shares without owning them (yet).


Thanks, this is exactly what I was looking for. I'm also glad, that I am not the only one confused about this type of trade.

What if the lender decided to sell the stocks that he had lent out? Would the trade need to be closed for the short seller, or would he have to repay immediately and short sell a new lenders stock?


It depends on where the shares were borrowed from.

Either they were borrowed from the brokerage firms inventory or they were borrowed on margin from another clients account. If they're borrowed from the firms inventory, it's unlikely the short seller will be affected, because the firm will just have you borrow against different shares in their same pool of inventory. If they have no more left, they can borrow from another firm. In the very unlikely scenario that the firm decides to not hold ANY more shares of that company, then you may get called on the stock.

In the second scenario, if you're borrowing from another client, however, you may be at risk of getting a margin call -- in which case you would need to purchase the shares on the open market at their current price and return them to the lender.


So if you get called, you have to get them back to the lender...


> What if the lender decided to sell the stocks that he had lent out?

The answer depends on the agreement between the lender and the borrower.

Suppose that I loan you my car and then decide to sell it. One possibility is that my agreement with you doesn't let me sell it (or forces me to come up with another car for you if I do). Another possibility is that my agreement with you says that the loan to you ends if I decide to sell.

Short selling is a form of borrowing. The only odd thing is that the thing that you have to repay isn't cash.

Consider a mortgage. The borrower rarely has enough money to cover the whole loan when it is taken out. Instead, the borrower hopes to have enough money to cover each payment as it occurs.


>Defenders of short-selling claim it helps quickly respon to fundamentals in the market place.

And we might get sane Price to Earnings ratios.



I just wrote a stock prediction system

Oooh, a bankruptcy engine! The most prominent art form of our times. ;)

You seem to understand that you've become dangerous to yourself and others. Be sure to keep listening to those thoughts. Just in case, you might want to get a tattoo: Past performance is not necessarily indicative of future results.


You do realize you're simply repeating commonly held bullshit wisdom, right?


For the vast majority who hold this common wisdom, it is not bullshit at all.


To be fair, I think lrm was responding more to the random walk, TA is bullshit mindset than to what was actually posted by mechanical_fish.


As someone who has also tried to write one, I'll agree with his statement. Often following the technicals works very well. But if you know nothing about the fundamentals, one of these days you're going to end up making a very bad trade. I wrote my system so as to limit my losses. Which seems to work well. In my opinion the best way to trade is to make a decision to enter/exit the market based on fundamentals, and use technicals to decide how you do so.


but you have to remember the vast majority of trades are made by humans and the vast majority of humans are emotional not always logical creatures. So the technicals which don't account for human emotions are bound to be wrong a certain (usually large)percentage of the time.


This is no longer true. Most trades are automated, to one extent or another. The intent is generally from humans, though--for example, if one person is bullish about a stock, and purchases 10,000 shares, it might lead to 30,000 more shares being traded by algorithms trying to capture profits from the tiny perturbations caused by this initial trade).

However, many stock trading algorithms appear to fade short-term trends and ride long-term trends (you can see this if you look at stocks with high hedge fund ownership; they tend to have gone up a lot, with any extreme moves quickly dampened).


I love you; you pay my rent.


The concept could be illustrated this way (ethical considerations aside):

Let's say that there is a high demand for electric generators after a hurricane. You "borrow" as many generators from out of state friends as you can, and proceed to sell them at a premium (let's say $1500 each). After some time passes you find them on sale at Home Depot for $500. You buy enough of them to return to everyone you originally borrowed from, making a tidy profit in the process.

To answer the question more directly, short sellers borrow stocks from other stockholders. And, yes, the people lending the stocks are hoping for the stocks' success.


Let's say that there is a high demand for electric generators after a hurricane.

Are you also from Houston?


I think there are plenty of good descriptions of the basics of short selling here, but I wanted to help explain the "who are you borrowing from" aspect.

When you trade, you must trade through a broker-dealer. A broker-dealer is authorized to trade on behalf of it's customers. A broker-dealer must uphold certain regulatory requirements put in place by the SEC, and policed by a variety of government and non-government entities, including organizations like FINRA.

Originally, shorting was managed by the broker-dealers. It was the responsibility of the broker-dealer to manage finding an entity to "borrow" the stock from (usually a large institutional client). These institutional clients own very large positions in the stock, and the broker-dealer normally provides a guarantee that it will be returned. If for some reason this process was mismanaged, when the trades cleared and settled, there would be a "fail to deliver" (meaning they weren't able to come up with the stock) This is a severe problem for the broker-dealer, and can result in them losing their license. Abusing this system became known as "naked shorting" where you never made an attempt to "locate" (borrow) the stock. Naked shorting was severely curtailed in 2005 under Regulation SHO.

You may also be curious how a customer knows what stocks its broker-dealer can borrow. Originally there was a black-list of sorts called the Hard-To-Borrow list. This list was stocks that were relatively illiquid and that couldnt be shorted freely. If you wanted to short these, you had to request a "locate" from your broker for a specified number of shares, and they would go looking for someone to provide it, and confirm how many shares they could find. Under Regulation SHO, this changed to a white-list "Easy-To-Borrow" model where you were only allowed to short stocks on the list freely and had to request locates for the remainder of the symbol universe.

Finally - another interesting note on shorting called the "uptick rule". The uptick rule was originally put into place in the 1980's under Rule 390. This rule was built to prevent a stock from being run into the ground by repeatedly shorting it while the price was already falling. It required that in order to short, the previous print (quote) must have been higher than the one before (the stock was heading up). This really didn't help the problem too much, and was repealed in 2007.


One other point to note here: when you open a margin account at a brokerage, you are asked to sign a number of agreements such as a credit agreement (officially recognizing that you will be borrowing money and specifying the interest rate), a hypothecation agreement (pledging the assets of the account as collateral for the margin loan and permitting the brokerage to subsequently re-pledge them as collateral to a bank from which it borrows the money that it loans you), and a loan consent agreement, which gives the brokerage the right to loan your shores to clients who wish to borrow stock for short selling. The broker will certainly require you to sign the first two, but according to the regs, they cannot require you to sign the loan consent agreement. However, I didn't see an easy way to opt out of it when I signed up for my account with a discount broker and it didn't seem worth the hassle to navigate their customer service to opt out even though lending provides them with a profitable business which I, as the ultimate lender, am not compensated for.


In case the borrower fails to deliver, the broker lose license, ok understood, but what about the stock itself? Does the transaction gets rolled back? Or will the total number of shares be permanently increased at the cost of the broker's license?

Edit: The lender must write off the stock?


Wikipedia matches my memory that the uptick rule was established in the '30s: http://en.wikipedia.org/wiki/Uptick_rule


Oops, you are absolutely right. I got confused. Rule 390 was much more obscure... It had to do to with selling NYSE listed stocks on ECNS and such.

It was under Regulation SHO that this got changed. Thanks for pointing that out!


You borrow from large institutional investors. These funds just own large amounts of stock in the hopes of achieving a profit through dividends and growth of the company. A trader who wants to short a stock can borrow some of this stock for a fee. Everybody wins this way. The large institutional collects the borrow-fee, and the trader can profit from a decline because he has borrowed the stock.

[pet peeve] Note that naked short is actually mathematically equivalent to (naked) long only with a minus sign. For example: every publicly traded company is naked short it's own stock from the day it goes public (collecting a huge heap of cash in exchange for selling the stock). Another example: Everybody owning stock (or anything really) is also short cash (unless they borrow money to buy it). So all people long [insert company name here] are short [insert currency here] i.e. they will profit when [currency] drops wrt to [stock]. Those unpatriotic bastards! [/pet peeve]


True. When you buy IBM on margin, you're shorting USD.

So if they reinstate the uptick rule for short selling, shouldn't they add a downtick rule for margin buying? :)


You borrow stock from someone (or your broker does) and you then sell the borrow stock. You give someone (usually your broker) a promise to give them back the stock at a later date.

That's it. In it's entirety.

Depending on the value of your portfolio/margin account, if the value of the stock goes up too much, they may ask for more collateral, etc. But other then that, there isn't anything to it.

Shorting a stock is a bet against the price of the stock. Honestly, it doesn't make sense as much as buying a put option in many cases, but sometimes it does. http://en.wikipedia.org/wiki/Put_option


Going to get down voted here but is anyone else concerned that we have people building price prediction systems and hedge fund accountants that admit they don't have a complete understanding of what a short sale is?


I won't down-vote you, even though I'm that hedge fund accountant you're talking about. :) Even without knowing all the minute intricacies of how the share lending occurs, my accounting results can still pass audits with flying colors, year after year.

Just in case anyone thinks I'm proud of my "ignorance," I'm not. I'm discussing things here in order to gain a better understanding, even though that understanding is not crucial to my performance as an accountant.

And yes, I am concerned about the current sorry state of so-called "markets."


If I'm a web developer but I have no idea how CPUs actually work or how a Cisco router sends my packets around the world, does that mean we should be concerned about the stability of the Internet?


When I worked in banking risk, accounting, finance, audit etc had very little understanding of the business, basic pricing & risking, market mechanics etc.


It's not that complicated, people are just too proud of their ignorance to bother learning (OP excepted since he went to the trouble of asking).


Short selling works like this:

Party A buys 500 MSFT shares from partner B today, and then immediately sells them at the current market price to C. Depending on the terms of the deal, party A must pay back the same number of shares at a later date to party B. Let's say 30 days later, party A rebuys 500 shares of MSFT at THAT current market rate (hoping it has decreased over the last 30 days), and repays the same number of shares (hoping it's a smaller $ value) to party B.

The people lending the short are expecting the stock to go up, the people buying are expecting it to go down.

Hope that helps


I've always seen the first transaction between A and B described as "borrowing", since no money changes hands at that stage.

You asked whose shares you are using to place the short. Mechanistically speaking, you, the short-seller, have to locate people willing to loan you the shares in return for some sort of consideration, usually a small interest payment. In practice, brokerages perform this service for you, often by using shares owned by other clients "on margin" (with credit from the brokerage). Your broker can probably give you, upon request, an "easy-to-borrow" list, showing the stocks that can be shorted without concern for how to cover your position.

In practice, short lenders usually don't participate knowingly in the short sale -- as mentioned above, they are often just other investors who own shares on margin (credit). So, they are generally hoping that the price of the share goes up (that's why they own the stock), but lending shares for a short sale has no connection with a particular market outlook.


> The people lending the short are expecting the stock to go up

They might agree that the stock is going to go down, but, because they're long, i.e. expecting the stock to go up over a long period of time (e.g. by the time they retire), they don't care, or at the very least isn't willing to make the gamble.

Also, there's a fee for the lending.


Usually the lenders are hedge funds, who hold large amounts of stocks of all sorts. They are playing a different game to shorters, and happy to get a fee for lending stock. So they make money in holding stock, which is what they were going to do anyway.


Actually, the biggest lenders are index funds.


If the lender of the stocks is long on the them, what incentive do they have to get involved in this workflow?


For one, it doesn't affect their pricing. If they're confident that the price will go up, then collecting some more money on lending fees is just icing on the cake.

For two, it helps to understand who actually owns shares. Most individuals trade in a "margin" account in which the trader gets some additional liquidity in exchange for lessened rights. These people don't actually own the shares they buy -- they are in fact owned by their broker, who keeps a pool of all the shares their clients purchase. Because of this, the broker can loan out some of the shares in that pool for additional revenue. If I remember correctly, there's little risk involved if the clients sold more shares than were still in the pool because the broker can simply call the loaned shares and force the borrower to find another lender. Additionally, dividends are not diminished by lent shares because the borrower is forced to pay the forgone dividend to the lender. There is, however, trouble with voting -- you can't vote shares you don't own, and your broker can't vote shares on your behalf if he doesn't own them either. So in effect, your voting power is diminished by the percentage of shares lent.

If you don't want your broker lending out your shares you can use a cash account instead. This puts the shares in your name, but you lose your ability to sell shares before the purchase has settled 2 business days later. Additionally you can't short-sell or borrow money. None of these are a great hindrance to a long-term investor though, so it may be worth the trouble.


Does it work, if the people lending it, are just planning to hold the stock forever?


I think holding duration is part of the contract.


I'm a hedge fund accountant, and my software follows many thousands of trades including short sales. I know exactly how to account for these trades, but I have no idea what's really going on.

As an accountant, all I see is that someone sold 1200 XYZ shares at $23.00 each, receiving a grand total of $27,600 cash. To simplify the example, I am not subtracting any commission there.

Now the funny thing is, this account didn't have any XYZ shares before the trade. Nevertheless the trade happens, and the account has -1200 XYZ shares, and $27,600 more cash than it had before.

At that moment, the account has incurred a liability to buy back 1200 XYZ shares -- eventually. The account can hold this liability indefinitely, so long as it has enough total capital to reassure the brokerage that it can easily buy back the 1200 XYZ shares at any time.

I've read the stories about "naked short selling," and how that's a giant scam because the seller doesn't even have to locate any shares to borrow. In this telling of the story, the seller is issuing brand new shares and selling them into the market -- in effect, counterfeiting. I spoke with a very experienced money manager about this, and that's his take.

I also spoke with a friend who is very wise about markets, and he had an entirely different take. He made the point that no matter how the short sale occurs, either "naked" or "covered", in both cases the seller ends up with the liability of -1200 XYZ shares, so what's the difference? The only difference is that if the short sale is naked, the seller owes the shares to the buyer. But if the short sale is covered, the seller owes the shares to the lender. Either way it's a liability of -1200 XYZ shares, and the only difference is to whom the shares are promised.

Now I'm a rational man, so it bothers the hell out of me to agree with both sides of a contradiction. So what gives? I don't know. The only other shred of evidence I have, and it's a very small shred, is the phenomenon of "Payment in Lieu of Dividends." If I have negative quantity of shares, and those shares pay a dividend, then that dividend is charged to my account as an expense. Normally, as an accountant, I see that as a simple negative dividend, which we call a "Dividend Expense." But sometimes I see those negative dividends labeled "Payment in Lieu of Dividends." I read an article once saying that the only difference is that "payment in lieu" occurs when the shares were sold short in a "naked" fashion.

So maybe, just maybe, there is a real difference between the two forms of short sales, as my money manager friend asserts. The money manager asserts that naked short selling actually increases the total supply of shares, even past the official "float" of shares issued by the company!

The people at the Gold Anti-Trust Action Committee (GATA) even claim that short sellers are creating this artificial counterfeit supply in the gold market. I would suggest calling their bluff and redeeming the physical gold into allocated Swiss storage -- but lo and behold, these financial instruments have no redemption contract. They're cash-settled only. How conveeeeeenient.

You asked if the people lending the shares actually hope for the stock's success. Of course they do. If someone borrows 1200 XYZ shares and sells them, the lender still has an asset of 1200 XYZ shares, and clearly still wants their price to rise. The seller has a liability of -1200 XYZ shares, and clearly wants their price to fall. The buyer has an asset of 1200 XYZ shares, and clearly wants their price to rise.

Note that in my example there, the total net quantity of shares in the three accounts involved is precisely 1200, both before and after the short-sale. So where is this alleged increase in supply from short-selling? Perhaps there's no increase in this case because it wasn't a naked short sale.

OK fine, let's make it a naked short sale. A trader simply sells 1200 XYZ shares without either having them or bothering to borrow them. Another trader buys those 1200 XYZ shares. Now the seller has a liability of -1200 XYZ shares, and the buyer has an assert of 1200 XYZ shares. So after the short sale, the total net quantity of XYZ shares in those two accounts is precisely 0. But the net quantity was precisely 0 before the short-sale as well! So once again, where oh where is this alleged increase in supply caused by short-selling?


The increase in supply is not caused by the final net position. It's in what you see when you look at the market.

Suppose there are 100k shares issued. Some traders decide to naked short 50k. Actual holders of the shares say, "Oh crap. Half the company is for sale - better dump my shares while I still can." So they put up a total of 75k for sale.

Now 50k of the 75k of actual shares need to be purchased by the people selling short, but if you look at the total number available for purchase at that point, you'll see 125k shares for sale - more than were ever issued.

Of course, this same issue can bite the short sellers in a "short squeeze". Suppose we own 60k of the shares in the company. If we see someone selling 50k, we know they are doing a naked short, and we should buy it. When we do, we will own 110% of the company. Obviously, to make things go to 100%, the short sellers need to buy the remaining 10% of the shares from you. You get to pick the price.

* Edited to add - you can see a recent example of a short squeeze in Volkswagen around October 2008: http://www.reuters.com/article/idUSTRE49R3I920081028


Well, the problem is less that there are more shares of a company for sale than currently exist and more that it can generate high levels of unrealistic downward pressure on a stock. With a normal short sale, there is some balance between the long and short side - that is, you can only short so much before the longs start buying again and stop the downward price movement, and there are only so many people willing to lend stock to short. Once the supply is gone and the price is in balance, you can't continue to short the company and the downward price movement stops, theoretically having incorporated negative market sentiment.

With naked short sales, you're removing the supply restriction, making it possible to continue to pressure the stock downward beyond where it should go in a balanced market. This sort of pressure can cause a panic among investors in the company and become a self-fulfilling cycle - once a company's stock is pushed below a certain level, many investors will dump the stock, regardless of the fundamentals of the company. It's not a cheap maneuver, but it's potentially phenomenally profitable for the people committing the short, and it's totally devastating to the company under attack. It also doesn't represent balanced market sentiment, nor the actual value of the company, and the company can be forced to take dramatic measures due to circumstances for which it wasn't to blame. It's a potentially highly destructive practice and banned for a very good reason.


Moral equivalent is, If you knew a self employed guy needed to sell his boat to keep his mortgage current, and you bought similar boats and sold them below cost so the guy would go into foreclosure and then you bought his property.


This is not the same. Once a company has sold stock it does not gain money from the ups and downs of the market. If it made agreements contingent on its stock maintaining a particular value then it has chosen a separate risk. A company cannot go out of business because its stock price is low. It can be bought by others but this also does not drive it out of business.


>It can be bought by others but this also does not drive it out of business.

If the company is now worth $1 and owns anything of value then it's going to be bought and asset stripped. It may not actually be out of business when it gets run down by short sellers for their own profit but it's effect is going to be pretty much the same - unless there's suddenly a lack of greedy business prospectors :0)

I suspect that the company isn't really going to be able to raise new capital any longer either (or will find it very hard) but don't know enough to confirm that.


Yeah, cost of capital is definitely a concern, for two reasons:

First, most companies fund new ventures via loans, etc., and the price of a company's stock and the company's overall valuation have a big impact on the terms a company can get on a loan - both how big a loan they can get and at what rate. Naked shorting materially worsens a company's ability to raise capital.

Second, most companies are operating on rolling credit lines - this is just a reality of doing business: Invoice Monday, get payment Wednesday, bills are due Tuesday. A company's stock dropping dramatically can cause these credit lines to be yanked, which can demolish otherwise solvent businesses.


These are great examples, and your point is well taken.

The https://loom.cc/faq system avoids this sort of nonsense altogether. An asset type such as 2fcb2b81bb96bb51cec88edcb4b9a480 might represent a real underlying asset being traded, but only the true issuer of that asset could create new units of it.

Anyone desiring to sell that asset short would have to create a brand new distinct asset type such as 6b17a53d425dbb15f933b98ace93e587. This new asset type would represent just that one individual's liability to pay back the original asset. So the new asset type would in effect be a simple loan contract.

With this approach, the supply of the original asset type 2fcb2b81bb96bb51cec88edcb4b9a480 remains completely unaffected, and nobody needs to panic.


I believe this is roughly how shorts are handled on the Lima stock exchange, through the mechanism of "Operaciones del Reporte" -- a peer-to-peer lending system on the exchange. These loans are fully collateralized, keeping the risk extremely low.


fexl, loom looks very interesting, and the maintainer (you?) actually touches up on some specific market-based ideas I've been sort of idly kicking around in the FAQ (e.g. phone service contract exchanges). Is there a way to get an invite/sponsorship to play around with the system?


Sure. I guess I could post it here, but maybe we could try hooking up at https://bonchat.org/9ff3842f90e90d5e with "katie tiny judd".

Or, more conventionally, visit the loom.cc web site and send an email from there (click Contact).


Please post and invite. I am sure many of us would like to try it.


7ae291850de6795268e019ee3e63c31a


taken


d302b24bb138e715e5c0cede42edd9f4

d9c48e12e7bf32fe3ce3410c4966b3bc


The d9c4 is retracted.


The d302 is taken.


afd4b44db6063e8a1286f9595c42822a


retracted


c1b1221342788225c1b60cd5d03a01a5


damn, I was to late. They have all been used. Sorry to be a PITA, but are you able to create a few more. Thanks.


Actually not, three are still available right now. I marked the two that were already taken.


Thank you sir. The two I tried happened to be the two that were used!


taken


I have simplified the section titled "How do I use Loom to accept payments from customers on my web site?"

https://loom.cc/?function=faq#shopping


    Suppose there are 100k shares issued. Some traders decide
    to naked short 50k. Actual holders of the shares say, "Oh
    crap. Half the company is for sale - better dump my shares
    while I still can." So they put up a total of 75k for
    sale.
I used to believe that, and wrote to this effect in this forum previously. However, I've since been told that you can find out in Bloomberg how many shares are out short on some exchanges, even if they're naked. Hence, my previous statements suggesting that you could inflate stocks to lower prices are probably incorrect.


By the way, such confusing issues (pun intended) can never arise in a system such as https://loom.cc/faq . There each asset type has a specific hexadecimal identifier, and the only way to create a liability is to issue a brand new distinct asset type.


What happens when I buy some shares from someone who happened to be short selling them naked, then I try to vote those shares in the next proxy vote?


The naked short seller has to physically deliver in 3 days, either with a loan, or by buying the stock.


I assume you buy the non voting shares.


I'm a bit confused about the supply being artificially raised during a naked short. I was under the impression that the brokerage actually lent me the shares to then sell, and it was my responsibility to return those shares at some point.

I suppose with any form of credit/debt, you can create a market with more shares than actually exist. You're selling the promise of shares.

The only other thing I can think of is that instead of trading the actual (or virtual) shares, the parties in the contract are trading a new instrument who's value is tied to the share being shorted.


You're assuming that the shares actually move from buyer to seller at the time of the transaction, which they don't. For the most basic of trades, it can take several days for the trade to close, so a naked short can sell shares they don't actually have and then hope that they can get some before the trade closes (I think it's 3 days but it's been a while since I thought about these things.)

In other cases, especially retail accounts, the shares are really being held in trust by the brokerage so they're not actually necessarily being moved, it's more of a pool where you have a specific claim on that pool based on the value of the assets in your account. (This is in fact where the "borrow" on a stock may come from - that same brokerage may be lending shares from that pool to people who want to short a stock - generally you can tell the brokerage not to lend your shares out to those shorting.)

The classic short squeeze example, by the way, is the recent Porsche / VW short squeeze where Porsche essentially screwed shorts by buying up so much of VW that there was only 6% of stock left in "float" while there was 12.1% of the company on loan to shorts. All of a sudden there were 2 shares of shorted stock for every 1 not owned by Porsche, and they could pretty much dictate whatever price they wanted to shorts desperate to close out their positions. Totally fair, very funny.


You can borrow money from a friend. Right? You can borrow stock from anyone who holds it. If your friend wants his money back, you can pay him cash and the bills don't have to have the same serial numbers as the ones you borrowed. Same with stock. (Entrepreneurs note: You are currency issuers. Think about that.)

The main difference is that everyone holds their shares at a broker so they let the broker handle this loan for them. You borrow the shares via the broker, the broker sells them, and then lets you have access to some of the proceeds (limited by regulation) and uses the rest as a low interest loan to itself.

Small brokerage accounts get nothing out of this even though they lent the shares. That's probably the main reason it seems so mysterious. Most people aren't aware of the mechanism. Your pension fund or insurance company is aware and makes sure they get a cut of the benefits of share lending.


Regular investing in the stock market is when you buy some stock, believing it will go up, so you can sell it at a profit at a later date.

If you believe the price of a stock will go down, then you can short it. This involves the opposite of regular investing, selling high first, then buying low later. To do this, you borrow the stock of someone else, with an agreement to pay them the stock back at a later date. You sell it straight away, then when the time comes to return the stock to the lender, when hopefully the stock price has gone down, you buy it back form the stock market, and give it back to the lender.

The lender of the stock usually gets some fee for lending it to you. They benefit, since they are just holding onto stock for the long term anyway.

Naked short selling is when you don't make an agreement to borrow the stock in the first place.

The losses you can receive from shorting stock can be huge, is the stock you sold goes up by a lot.


Regular investing in the stock market is when you buy some stock, believing it will go up, so you can sell it at a profit at a later date

That's speculation, not investing. I think it's important people understand the difference.


That's only speculation to the extent that any investment is speculative.

I don't play the market ... I buy mutual funds for my Roth IRA, and I sit on them. And sit on them. And sit on them. But if you were to reduce my actions down to the bare basics, it would sound just like the initial comment: "you buy some stock, believing it will go up, so you can sell it at a profit at a later date". Just because my window is 30 years, and not 30 days, it doesn't change the basic mechanics or principles.


Really? Given the statement above, which boils down to: "buy low and sell high", what's the difference? Generally, market microstructure tells us there are speculators and value investors, both serving a due purpose in the functioning of a market. Value investors are most adequately described as those who buy an asset below market value, rather than at or above market value. Both types of market participants are in it to make a profit.


The difference is, for the value investor, the selling part is optional. A company can repay its investors with dividends, liquidation (rare), being bought out... Often value investors end up selling to the market, but you have to break away from the mentality that buy low sell high is the point of "investing". If it is that way, then it's a zero-sum game, so why's it an important part of capitalism again?


Ignoring liquidation and acquisition, because they are rarely the goal of a value investor...

Dividends do repay investors, but the price always adjusts ex-dividend. A value investor is not happy owning a declining asset even if the dividend pays at regular intervals. They always look for capital appreciation and will, whenever they deem appropriate, convert unrealized gains into realized.

You seem to be referring to buy & hold. Taking the Dow as a market proxy, if you bought BEFORE June 1999, you are currently at break even... over 10 years later. Congratulations, you're strategy is working out perrrrfectly.


A value investor would not have bought a broad market index in 1999, where the P/E-10 was, IIRC, somewhere around 40!

I have to say I'm not particularly interested in discussing this with someone who thinks the classic value investing paradigm is comparable to buying and holding an index at the worst possible time.


Re-read the last sentence. You're not paying attention.


    If it is that way, then it's a zero-sum game
No, because the amount of value in the system trends up over time. There is not a fixed amount of wealth in the world.


The point is that stocks are not a priori worth money just because they represent a share of a company. Value has to come from them somehow.


The losses you can receive from buying a stock can be huge. The stock you bought could go to 0.


The upper bound on what you can loose from a long strategy is the money you invested. No such bound exists on a short strategy. If you sell short at $1, and the next day something happens and the stock jumps to $5, or you end up in a short squeeze, you could bankrupt yourself.


A few things: (and it seems lots of folks here know just enough to be dangerous)

1. Naked Short Selling is illegal. There is an exception for market makers that allows them to trade naked shorts but that is beyond the scope of this discussion.

2. All short selling done by retail customers, hedge-funds, etc. is all 'covered short selling'. This means that the stock being sold is first 'borrowed' from a third party. The third party is paid interest on their loan of stock which is their incentive for loaning it out.

3. There is no absolute time limit on the duration of a short position, but long-term short positions are difficult to hold because you still have to pay interest on the stock your borrowed which eats into potential profits.


I used to trade bonds (amongst other stuff) so I can tell you how it works for bonds. Presumably it's similar for stocks:

As you know, going short means you sell the bond/stock. Generally going short implies you are going negative, as opposed to selling inventory you already own. So if I go short 100 million 10y bunds (German government debt) this means I sell 100m bonds I don't have.

The guy I am selling to doesn't know I am going short, he just knows I've sold him the bonds and he expects delivery at the end of the day (or possibly in 1 or 2 days time, depending on the definition of "spot" and various other things).

So I have to deliver him 100m bonds I don't have. Where do these come from? This is where the "repo" or repurchase market comes in to play. Very simply, the repo market is short-term buy/sell market: Party A agrees to sell Party B some bond at some price, AND additionally agrees to buy it back a short while later for a slightly higher price. What Party A has effectively done is borrow money from B and put up the bond they own as collatoral.

So what happens after I short my bond is that I go to the repo traders and say "hey - I'm short 100m bunds, you need to do a repo trade to flatten my position". So these guys will loan out some cash (around 100m euros) and take as collateral 100m bunds. These I use to deliver to my seller.

Edit: In reality I don't tell the repo traders I've gone short a bond. It's their responsibility to make sure all positions are repo'd out. They see a netted view of all bond positions across the bank and repo just the net positions.


The mechanics have been adequately explained already so no need to go into that again. One thing that should be pointed out (and this is no indictment of shorting; I do it on occasion) is that since a stock can only go down to $0, there is limited profit. It can theoretically go up without bound, so there is a risk of losing without bound too. Practically, these risks are limited, but also practically, the maximum profit is also.


To make money with stocks you want to buy cheap/low and sell for more/higher. It doesnt have to be in that order.

If you expect a stock value to go down lower than X dollars, you commit to sell them stock at >X$ (without owning) and, when the time comes and your expectations (about the stock going down) become true, you buy for <X$ and sell the stock for >X$.

-- MV


Simply put, a short sale is borrowing a stock from an institution, and selling it on the market with an obligation to cover the sale (return the value of the stock back to the borrowed party).

Now if the price of the stock goes up after you sold it, depending on how wide the margin becomes, you can stay in the contract, but guarantee more cash to the provider so that they are confident you will be able to cover it the future.

If the stock goes down, you can close the contract and return the value of the sale back to the institution, and effectively pocket the retained cash value of the purchase from when you first sold the stock short; turning a profit from a decline in price.

Often times there are companies out there that are running on fumes, overvalued, or are partaking in fraud; short selling is a useful tool that can help the markets discover new information about possibly shaky institutions.


The article linked below describes Porsche's short squeeze and contains one of the best explanations of short selling I've come across to date.

http://radian.org/notebook/porsche


Not sure if it's 100% relevant, but this was a fun/semi-informative read on shorting stocks:

http://www.wired.com/wired/archive/8.04/dumb.html


Regarding who the shares are borrowed from, from my understanding, any client who signs a margin account agreement also signs something that says "sure, you can borrow my shares, and lend them to another person". Your account will never show it, and presumably there's no way to actually lose those shares (between insurance, and the margin allocated on the borrowers side).

As other people say "large institutional" investors most likely provide a nice pool of shares as well, which their agreements with the brokerage allow to be shared out.


I think the idea is that the people lending are planning to hold onto those stocks over a long period of time, so they are hoping that in the long run the stock price goes up.

While they are holding onto them, money can be made by lending out the stock. The security lender will lend stock, get a fee for doing so, and will hedge against risk by getting collateral for the stock they lend.


Naked Short Selling needs a new name. It sounds like Short Selling which is quite legitimate way to bet that a stock price will decline. Markets need traders who will spot problems at say Enron and bet against them.

But Naked Short Selling is simply fraud. It needs a new name.


What is the difference if you arrange the loan required to short sell before of after you do the short sale?


Before you take a position in a stock you should research the stock to find out what it is worth.

If a share is worth more than the current price you should buy it. If it worth less than the current price you should short sell it.

If you don't short sell, then half of your research is wasted.


There is pretty interesting illustration of Naked Short Selling here: http://www.rollingstone.com/politics/news/12697/64824?RS_sho...



the key is equivalence, rights of ownership and contracts, standardized at 2 or 3 different levels.


There are many sources of stock for stock loan. 25 years ago, the primary source was stock in the margin accounts of investors. Today, nearly every large holder of stock loans it out. The reason they loan it out is to make more money.

Virtually every broker/dealer (b/d) that holds their own accounts has a stock loan desk (small to medium sized firms frequently have their accounts an another firm's books on a fully-disclosed basis). Virtually all large index fund managers have a stock loan desk as well. The stock loan desk at a b/d will loan stock to the firm's customers from the available shares (more on that in a moment) or it will find another place to borrow the shares from on behalf of the customer. This can involve looking in a system called Loannet or merely calling up other participants in the market.

The original source of available shares was the margin accounts of customers. The amount of stock available for loan depends on the amount of funds loaned to the customers. The stock loan activity is completely invisible to the customer whose account the shares are taken. Don't want your shares loaned? Don't use a margin account. Stock loan is the financing mechanism that provides the funds loaned to you for your margin account.

Securities can also be loaned from fully-paid (non-margin) accounts of customers with the written consent of the customer. It's a pain in the ass from a regulatory and operational point of view. It's usually only done if the customer has a really large holding in a hard to borrow stock. The customer generally negotiates a share of the revenue from the transaction.

In the past 25 years, institutional investors have started to loan stock as well. The pioneers were index funds, but it has spread to most other fund types. The big institutional investors generally set up their own desk and participate in the market directly. Being a direct participant can improve their ability to borrow stock as well.

The borrowing party puts up collateral (100-110%) for the stock and the lending firm either uses the funds to finance the margin business or puts it in a limited class of interest bearing accounts (I forget the name and regulation) at a bank. The borrowing party gets the stock and promptly sells it. The amount of the collateral is trued up to the value of the borrowed shares on a regular basis, so the risk to the lender is small.

So it is clear that one reason to loan the shares is financing. The second reason is revenue.

The revenue comes from the interest earned on the collateral. The interest on the collateral belongs to the lender except for a negotiated "rebate". For most stock, the rebate is generally 10 to 25 basis points less than the overnight benchmark (fed funds). The lender keeps what they can earn over the rebate.

Notice that I said "for most stocks". Some stocks can be hard to borrow. The supply can be low because large amounts of the stock are held in non-margin accounts or by investors who don't loan it out. The demand can be high because there is a large amount of short interest in the stock already.

The negotiated rebate on hard to borrow shares can be negative, and not just a few basis points. The negative rebate for a really hard to borrow can be negative 10 percent and worse. And a negative rebate means that you're paying somebody interest to hold your money as collateral.

This can be very lucrative for index funds based on a broad index like the Russell. It's one reason index fund fees are so low.

At the other end of the scale is generally available stock. Known as GC (general collateral), loan transactions in this stock are usually initiated by a stock lender looking for financing.

From a b/d point of view, stock loan is one aspect of a business called prime brokerage. Prime brokerage is a bundle of custody, operational, financing, and loan services offered to hedge funds.

One note, the perspective I've provided is largely from the institutional trading side of the b/d business. Retail investors borrowing stock will generally see a tier of rebates (I think the most common rebate is zero).




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