Here’s a definition I found of stock short selling:
In a short sale, investors sell borrowed stock, hoping the shares fall so they can buy the stock at a lower price, return the shares and pocket the difference.
So can anyone explain what’s in it for the one who loans the stock? I just can’t wrap my head around this.
The lender of the security gets paid a certain amount of interest.
Thanks Hogart, but that doesn’t help. To use Facebook as an example, the shortseller gains 6 bucks when it it goes from 38 to 32. Who does he sell the stock to? And how can he give it back if he sold it? Who owned it to begin with?
Stocks are fungible.
Does that help?
It’s not like selling the physical atoms of bicycle and magically make another reappear to give back to the original owner.
I’ve been re-reading the description of how short-selling works for months, and I still can’t grasp it. I know the final result: you’re betting against a stock (or fund). And instead of using the words buy and sell, we use the words *short *and cover. But I’ll never comprehend the inner workings of the transaction.
Step 1: You find someone who owns the security and who is willing to loan it to you. For example, an investment bank or a big institutional investor like a pension plan.
Step 2: You sign an agreement that you will borrow the security today and return the security in one week (say) along with an interest payment in cash.
Step 3: You now have a share of stock that you can do whatever you want with. So you sell it to someone who wants to buy that stock. Whom do you sell it to? It doesn’t really matter; your stockbroker will find someone who wants to buy it, presumably.
Step 4: A week passes and you now have to return the security, so you buy it back from someone. Again, your stockbroker will find someone who is willing to sell it. Hopefully the price went down!
Step 5: You return the security and the interest payment.
No that doesn’t help. If I loan you 10 dollars, I understand that you may not return the same 10 dollar bill. I don’t understand how this relates.
Ah, thanks Hogarth, I get it now. That definition leaves out a step - the buying it back part. Okay, I’m happy.
Maybe you just missed it:
“In a short sale, investors sell borrowed stock, hoping the shares fall so they can buy the stock at a lower price, return the shares and pocket the difference.”
(Emphasis mine.)
doh
Maybe that wording is confusing because it doesn’t emphasize the time span between transactions.
“In a short sale, investors sell borrowed stock, hoping the shares fall so they can later buy back the stock at a lower price, return the shares and pocket the difference.”
I understand that Morgan Stanley spent a bundle buying Facebook to prop up the price on that first day. So are they out actual money? Forgive me for being an idiot. I just really want to understand this.
Imagine Beanie Babies in the 90s. Rainbow Bear was selling for $2000+ (or whatever). You find that to be ridiculous and think that Rainbow Bears are in a pricing bubble. You have a friend that actually owns a Rainbow Bear.
You: Can I borrow your Rainbow Bear? If you want it back, let me know, and I’ll give you a replacement.
Your friend: OK, but I’m going to charge you $1 each day you have it.
You: Fine.
You then go on eBay and sell your borrowed Rainbow Bear for $2000. Two months later, the hype has died down and the market price for Rainbow Bears on eBay is now $1000. You buy a Rainbow Bear for $1000 and give it back to your friend.
You have made $1000 (sold for $2000, bought back at $1000) minus the $1/day you owe your friend = $940.
Your friend has made $60 from you (60 days x $1/day).
Short selling in the stock market works in pretty much the same way.
I follow this but would also like to know; What is the mechanism whereby one ‘borrows’ a stock? I know how to buy or sell a stock; I call a broker or do it myself via etrade or something like that. But how does one do a ‘loan’?
You’re not an idiot for having difficulty understanding such financial instruments.
If M&S loaned the stock, M&S is out of actual money in the sense that stock they own went from 38$ to 32$. This is a loss they would have suffered even if they had never loaned the stock. They compensated some of that loss with the interest that was paid to them by the short seller.
If M&S didn’t loand the stock and just spent money to prop it up (I’m not sure many investors do that), then they have lost money because it went from 38$ to 32$. I’m not sure how this relates to short selling though. Short sellers are often accused of causing price falls but I’d like to see something more solid than “they’re bad because they profit from someone else’s misery” as evidence.
If I may pile on with a related question: About how much interest is common in such transactions?
So did Morgan Stanley actually “own” the stock or initially were they more like a “consignment” store (I’m talking about before they bought up shares trying to prop up the price) getting a fee on the stock sold? I too would like to know how a brokerage “loans” stock it may not actually “own.”
Large institutions/broker-dealers have special departments whose job it is to borrow/lend shares for themselves and their customers. ETrade, or whoever your retail brokerage is, has relationships with other brokers. If necessary, they will call around and ask to secure a “locate” on a block of stock that someone wants to sell short. A huge determinate of how easy (cheap) it is to short stock is how many shares are outstanding - the float. Companies with very large floats will generally be less expensive to borrow. Companies with very small floats tend to be more expensive to borrow and more susceptible to what is known as a short squeeze.
As far as you are concerned, you don’t. You choose “short”, and this whole process happens behind the scenes. As a retail investor, you don’t really need to be aware of the borrowed shares. The process works like this:
You choose to short the shares, much like you would choose to buy or sell the shares.
When you exercise the trade, money APPEARS in your account, and you are short the shares, which is noted in your positions.
When you buy, you are no longer short the shares - you’ve covered the short. If you’ve bought for less than the sale, you get to keep the difference.
Some wrinkles:
Your account has to be a “margin” account. This means that you can be loaned money by the brokerage to buy securities. At a fairly high interest rate. If at any point, you do not have the cash in your account to cover the short, you are on margin, and paying interest. This can happen if the stock you shorted goes up, or you use the funds from the sale to buy more securities (a form of leverage).
If interest is paid on your cash balance (no much of an issue these days), the brokerage will generally not pay it on the cash balance needed to cover your short.
If the thing you shorted pays a dividend, it comes out of your balance (you have to pay the owner of the “borrowed” shares).
Absolutely not! It’s kind of an odd idea to borrow something and then turn around and sell it.
The company I work for does securities lending (among other things). So we happen to know that one of our clients is a pension fund that has a bunch of shares of Facebook (or whatever) that they’re willing to lend out, in order to make a little extra interest on their investment. So if another financial institution like Goldman Sachs comes along and says they want to borrow some shares, we set up the deal between GS and our pension fund client.
How does average Joe on the street short a stock? I don’t know if it’s even possible, but I suppose he calls up his stockbroker and his stockbroker calls a financial institution’s securities lending department.
Or maybe it doesn’t usually work that way at all; obviously I’m biased by what goes on at our company.
EDIT: Trom answered your question better than I did.
I believe retail brokers generally just keep the proceeds from their securities lending business. To make it worth both your and your brokers time, you need to have a pretty large portfolio to actually see any of the proceeds from securities lending.
See this linkand click on “Interest Paid to You” for an explanation.