Thursday, January 7, 2010

Short Selling

A man trying to sell a blind horse always praises its feet

This is one of the most intriguing concepts I have come across after Options, in my recent spell of reading. Someone profiting from things going bad around him. That is the essence of short selling. What an idea Sirji :-P. I have commented in my previous posts a couple of times that "going short" means profiting from prices going down and "going long" means profiting from prices going up. We dig into this more now. Short selling means selling something that you don't own directly. In this, the trader borrows stocks from someone and sells them in the market. While doing this, he expects that the prices of that stock will go down. He then buys back those stocks from the market at the new lower price and returns them back to the person he originally borrowed from. The spread, as usual, is what he pockets.

Who are the players involved?
 A short seller borrows stocks from his broker, which he then sells in the market. The broker on his part doesn't really buy the stocks and lend them to the short seller. He would already be holding brokerage accounts from several other investors. These investors would have bought shares using their brokerage accounts. The broker will lend these shares that are lying with him to the short seller. Thus, the original investor who had bought the shares becomes the lender.

Its all because of fungibility...
The reason why the broker was able to confidently lend someone elses shares to the short seller was because a share as an entity is fungible. Fungibility is the property of a good or a commodity whose individual units are capable of mutual substitution. Examples of highly fungible commodities are crude oil, wheat, orange juice, precious metals, and currencies (courtsey wikipedia). Thus, when the lender demands his shares back, say when he wants to sell them, the broker can in turn give him shares belong to some other investor holding a brokerage accout with him. Brokers typically hold a pool of securities in their brokerage accounts, so that they can transfer them to-and-fro. 

The lender retains his rights...
While the broker has lent the investors shares to the short seller, that does not expropriate the normal rights the investor would enjoy as a shareholder. He still retains the right to vote as a shareholder. The short seller does not get this previlige. Also, when the company pays dividends, they will actually go to the short seller. But since he doesn't really own the shares, he is obliged to pay the broker the amount of dividend he received who then transfers this sum to the original lender.

Some terminology:
If the broker falls short of shares in his pool, and if the lender wisher to sell his shares, then the broker asks the short seller to return him back the borrowed shares. This is called calling back. This prompts the short seller to buy back at the current market price and return the shares. This is called covering position. The process of broker finding a lender to lend stocks to the short seller is called locate.

Margin accounts:
When the short seller borrows shares from the broker, he has to open what is called as a margin account. The broker will ask the short seller to put something as a collateral for the even that the short seller defaults. Thus, the short seller puts some amount in this margin account as a collateral. These accounts are evaluated daily. The broker is expected to maintin some minimum sum in this account. As the stock prices move, so does the value of money in this account. If the price go up, the short  seller will have to put more money into his account. For this, the broker makes what is called a margin call. For e.g. if the short seller shaorts 100 shares at $5000 at time 't'. and at time 't+x', those 100 shares are worth $5500. Then if he is required to maintain lets say 45% of the total value of his shorts in his margin account, then the broker will make a margin call of another $225 tothe short seller at time 't+x'.

So how does each party earn money?
As explained till now, the short seller earns money if the prices fall down and he pockets the spread. When a borrower shorts shares, the proceeds from it are kept in his brokerage account with the broker. The broker will put this sum on interest to earn some extra bucks. The short seller is not entitled to this interes since he does not really own the stocks. Further, the broker will also put the money in the margin account on interest, which goes into his pocket. Aslo, the short seller is charges some basic fee by the broker for providing short selling services. In case of lenders, the earnings vary depending upon the size of  the investor. For small investors who have just bought a few shares through their brokerage accounts, they dont really get any share in the short sell pie, since the broker is eligible to allocate their shares to some other borrower without their knowledge as long as he can return them back when asked for. However,  there is a group of large institutional investors who explicitely with to lend their stocks on rent. This is known as securities lending. They do this via a custodian lends stocks on their behalf. The brokers, in such  cases, give a part of the interest they earn to these lenders (because of their size). Also, the dividends and right to vote are held by the lenders as explained earlier. Note that the lender is obliged to the interest on his stocks only if he owns them in entirety i.e. he himself hasn't put them as a collateral with  the broker.

What metrics are used by short sellers?
The short sellers generally employ a set of complicated metrics to analyse the markets. Few of them are -
  1. Short interest: This denotes the total number of stocks that have been shorted in the market and haven't been  repurchased back.
  2. Days to cover (DTC): This denotes the relationship between the number of shares that have been legally shorted in the market and the number of trading days needed to repurchase them back. 
Besides these,  they use techniques such as - locating the worst performing stocks in the market, using insider information to bust inflated company accounts, waiting for "bubbles" to burst like the dotcom bubble in 1996.

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