Short selling and securities lending

Buy a share and the most you can lose is what you paid. Sell one you do not own and there is no limit at all. Short sellers profit when prices fall, and when they are wrong, they can be wrong without end.

Imagine a friend lends you a concert ticket that is selling for £100. You sell it straight away for £100, promising to give your friend an identical ticket before the concert. If the price drops to £60, you buy one, hand it back and keep £40. If the price jumps to £300, you still have to find a ticket, and you are £200 out of pocket.

That is a short saleSelling shares you do not own, having borrowed them, in the hope of buying them back later at a lower price.. An investor who thinks a share is overpriced borrows it, sells it at today's price, and later buys it back to return to the lender. The profit is the fall in price, less the costs of borrowing. Buying a share in the usual way is called going long.

Where do the shares come from? From securities lendingLending shares or bonds to another firm for a fee, against collateral, with the right to have them returned.. Large long-term owners, such as pension funds, insurers and index funds, lend shares they plan to hold anyway, usually through their custodian bank. A hedge fund borrows them through its prime brokerA bank that provides hedge funds with services such as borrowing shares, financing and settlement.. Step through the life of one loan:

Why short? Some short sellers bet against companies they think are overvalued or fraudulent, and their research has exposed real accounting frauds. Many more short to hedge: a fund that owns one bank's shares may short another's to remove the risk of the whole sector falling. Market makers short to fill buyers' orders. Shorting adds sellers to the market, which helps prices reflect bad news as well as good.

The risks. Which of these is the short seller's problem? Pick one for each.

The profit or loss of a short position, shown in full. With $N$ shares sold at $P_0$, bought back at $P_1$, a borrow fee $f$ a year for $d$ days (actual/360) and dividends $D$ per share paid while short:

The price term can be at most $P_0 N$, if the price falls to zero. As $P_1$ rises, it falls without limit. That asymmetry is the opposite of the limited liability of L1.5.01. In practice the fee accrues daily on the current value of the shares; using the starting value keeps the example simple.

Start at the worked example below. Slide the buy-back price above $50 and keep going: the short line keeps falling. Then raise the borrow fee to 30%, as happens to crowded shorts, and watch the break-even price drop.

A hedge fund thinks Ridgeway Retail, a US chain, is overvalued. It shorts 10,000 shares at $50.00. The borrow fee is 1% a year, accrued actual/360 on the starting value; collateral is 102% of the shares' value. All amounts in US dollars.

Now the same trade when it goes wrong.

In the EU, the Short Selling Regulation requires anyone with a net short position of 0.1% or more of a company's shares to report it to the regulator, and to disclose it publicly from 0.5%. It bans naked short sellingSelling shares short without having borrowed them or arranged to borrow them. of shares: the seller must have borrowed the shares or have a firm arrangement to borrow them. In the US, Regulation SHO requires a broker to locate shares that can be borrowed before a short sale, and Rule 201 restricts short sales in a stock whose price has fallen 10% in a day. In the 2008 crisis, regulators in the US, the UK and elsewhere temporarily banned short selling of financial shares.

• A short seller borrows shares, sells them, buys them back later and returns them, profiting if the price falls.
• Shares are borrowed through securities lending, from long-term holders who earn a fee and are protected by collateral.
• Net P&L = (sale price − buy-back price) × shares − borrow fee − dividends paid to the lender.
• The most a short can make is the sale value; the loss has no limit. Recalls, margin calls and squeezes can force a close at the worst time.
• Regulators require disclosure of large short positions and ban naked short selling in the EU; the US requires a locate.

Short sale

Selling shares you do not own, having borrowed them, in the hope of buying them back later at a lower price.

Securities lending

Lending shares or bonds to another firm for a fee, against collateral, with the right to have them returned.

Lender

The owner who lends its shares, typically a pension fund, insurer or index fund, often through its custodian bank.

Prime broker

A bank that provides hedge funds with services such as borrowing shares, financing and settlement.

Collateral

Cash or securities the borrower hands over to protect the lender if the shares are not returned.

Borrow fee

The annual rate the borrower pays the lender, charged on the value of the shares borrowed.

Recall

The lender's right to ask for its shares back, which can force the borrower to close the short.

Manufactured dividend

A payment the borrower makes to the lender equal to any dividend paid while the shares are on loan.

Short squeeze

A sharp price rise that forces short sellers to buy back, which pushes the price up further.

Short interest

The number of shares sold short and not yet bought back, often shown as a percentage of the free float.

Naked short selling

Selling shares short without having borrowed them or arranged to borrow them.