Short Selling and Stock Lending

Equity investment used to be such a simple idea. You bought shares, the price went up and then you sold them for a profit. If the price went down you held on, received the dividends and told everyone that you were a long-term investor.

There is however a Through the Looking Glass version of this world: one where traders sell first and then buy the shares after the price has fallen. And in this Lewis Carroll world instead of receiving dividends, when the trade goes wrong you have to pay these out. Welcome to the upside down, inside out world of the short seller.

It is important to say early on that this is very different from the world of ‘short ETFs’, which are another matter altogether. Before we venture deeper into the domain of the short seller we must solve one glaring impossibility. How does one sell shares one does not have? Given that the buyer on the other side of the trade is doubtless eager to receive their new purchase, the seller has to deliver stock on settlement day. This is where the stock lender steps in with a simple solution. The short seller borrows shares from someone else in order to hand these over to the new buyer.

Now let us deal with dividends. Imagine that you are a shareholder in Vodafone and that you have loaned some of your shares to a short seller. This is only a loan after all, you will still want your dividends. But you can’t have them as the chap you gave your shares to has already flogged them on to someone else. The short seller thus has to pay you the dividends to which you are entitled.

Then there is the fee. If you are loaning out your shares, then it is only reasonable that you should charge for this. Imagine again that you are a unit trust, or a life fund, or a pension fund holding gargantuan amounts of every share under the firmament. Is it not common sense to try to make extra returns (and to outperform) from charging fees to lend your shares to someone wanting to borrow them? Seems like free money.

The risk though is that the fund to whom you have loaned your shares fails to pay a dividend or is unable to return your shares. Short selling can become loss making very quickly, with the seller exposed to a rising share price, plus paying a fee and being liable for dividends.

At times ‘going short’ is more than an exercise in analysis and patience. It can easily get down and dirty. Sellers can accuse companies of anything from misfeasance to outright fraud. Companies in return can accuse the shorters of libel, slander, market manipulation, pillage and possibly even germ warfare. This was recently vividly illustrated by a hugely acrimonious spat between the British company Quindell and the American investor Gotham City Research.

Short selling need not involve attacking a business: it can be part of a magic potion that makes money irrespective of whether markets move up or down. This can be as simple as believing that Shell is cheap relative to BP: if we were convinced by this, we could short BP and buy Shell. All that is needed thereafter is that Shell rises more or falls less than BP. If correct, the trade makes money irrespective of the direction of markets. And that’s magic.