Short Selling and Stock Borrowing

An explainer – is this an option in New Zealand?

Why would you want to borrow or lend stock? Just as one can lend money to another, one can also lend stocks or shares to another party.

The main reason for borrowing stock is the ability to sell a stock that one does not own; commonly known as short selling. Short selling, or in common parlance, ‘shorting’ a stock, is a trading[1] technique in which a trader attempts to generate profits by predicting a stock’s price decline. While the technique is commonly used to short stocks, it can also be applied to other securities, such as bonds and currencies. The lender of the stock gets a commission for facilitating the lending; the borrower receives an opportunity to take advantage of market conditions.

Short-selling is done in anticipation of a stock price decline. The short seller sells the stock they expect to fall, then buys the stock back after it has fallen and pockets the difference. For example, the shares of company ABC are trading at $1.00 per share. You believe this price to be too high and expect the stock price to fall. You borrow 1,000 shares from a broker or someone willing to lend you the stock and sell this stock on the open market for $1,000. A little while later (you anticipated correctly) the stock price falls to $0.50 and you buy the stock back for $500. You return the stock you borrowed and owe to the broker fulfilling that obligation and you pocket the difference of $500.

The above example is a simple illustration only; there are costs involved for borrowing stock as there would be for borrowing money. The lender, naturally, requires compensation for risk. There are also additional transactions costs not limited to brokerage and interest charges.

Risks

Shorting stock is risky. It is worth bearing in mind that when borrowing and short-selling, the upside gain is limited to the price of the stock (ie a $1.00 share can only fall to $0.00) but the downside risk is unlimited (ie a $1.00 share can rise to any amount).

Imagine using the above example that you shorted the stock at $1.00 but then the share price went to $4.00, and you had to buy back the shares. You would then have made a loss of $3,000. All the while, the maximum profit you were ever potentially going to have was $1,000 ($1 x 1,000 shares). With short selling, potential profits are limited, potential losses are infinite.

To highlight a quote from John Maynard Keynes, “Markets can stay irrational longer than you can stay solvent.”

Apt indeed when applied to shorting stocks. Using the above example, if a position turns against a short seller (shorter), the lender of the stock will require some collateral or margin. If a position goes against the shorter and the margin is breached, the lender often has the option to terminate the position and buy the stock back. Invariably, this will result in a loss to the shorter.

There is also dividend risk. If you are selling a stock short and the company declares and pays a dividend, then that obligation is yours to pay. If using the above example, company ABC paid a $0.10 dividend, then the amount of $100 also has to be paid to the lender of the stock. (1000 shares x $0.10).

New Zealand’s imputation credit system complicates this matter further.

In New Zealand

Short-selling and stock borrowing has never been as popular in New Zealand as it is overseas, and the NZX has never actively promoted the concept.  However, there is a local provider who offers this service. Wellington-based Leveraged Equities can facilitate short sales for interested traders.

Global brokers, for example IG.com and CFC markets, that also operate in NZ provide short selling services. These utilise synthetic products called “Contracts for Difference” or CFD’s (no actual shares are bought and sold) – you are often trading against the firm you deal with.

Arend Lanser

Footnotes

[1] It must be noted that this leads to tax implication which this article does not cover, but profits from short selling would likely come under the IRD’s definition of income.