Thursday, September 25, 2008

Yet Another Way to Screw the Shorts

Short selling is dangerous. Since a stock can only go to zero and can theoretically go to infinity, a short's upside is limited and the downside unlimited. Shorts can also be outlawed by the government, as many of us found out first hand last friday. Now there is yet another reason it sucks to be a short: it is getting harder and harder to borrow stock.

In order to be compliant, a trader who wants to go short must either be a bona fide market maker or meet the requirements as mandated by the SEC. This means that you have to locate and borrow the stock before you can sell it short. Most brokerages have an easy-to-borrow list and charge little to nothing for the ability to short stocks on the list. Some stocks, however, are harder to borrow and thus carry a higher charge for borrowing them.

The stock you or I borrow to short a stock usually comes from a margin account of somebody who is long the stock with your broker. Because he bought it on margin, technically the stock belongs to your broker, who earns a fee or commission for lending it to you to sell short.

Another source for borrowed stock comes from large pension and hedge funds who want to be both long the stock and earn a return from lending the stock out to shorts. Lately these institutional investors have realized that it is not in their best interest to lend stock for shorting. The thinking is if they do not lend stock out, it will be harder to borrow stock for shorting; the awful thing is that they're right.

Anecdotally I have noticed my borrowing costs increasing since last week. I have also read that big pension funds like CalSTRS are reigning in their stock loan operations hard. The managers of CalSTRS said they would no longer lend stock to the "piranhas" that stalk the markets' murky waters.

Everyday it gets harder and harder to be a short.


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