The Lemon Fool

I have been wondering about a detail in my understanding of short selling. As I understand it:-

Person A wants to short the shares in XYZ plc. They borrow the shares from Person B, pay them a fee for the privilege of borrowing and then sell the shares. Assuming the price of the shares go down, Person A buys back the shares at the lower price, making a profit on the price difference. So far, so good. However, Person A now gives the shares back to Person B who ends up with a holding in XYZ plc that is worth less, possibly a lot less, than it was before the shares were lent to Person A.

How does Person B benefit from this apart from the borrowing fee which must be less than the before and after price difference? ('m working on the assumption that Person A wouldn't borrow the shares and pay a borrowing fee if they didn't think they could make a profit bigger than the cost of the borrowing fee.)

All enlightenment gratefully received.

PinkPony wrote:How does Person B benefit from this apart from the borrowing fee which must be less than the before and after price difference?

B just gets the fee. If B is a index tracker fund or required to tightly follow a benchmark, it has no option but to hold the shares as they fall.

Alaric wrote:

PinkPony wrote:How does Person B benefit from this apart from the borrowing fee which must be less than the before and after price difference?

B just gets the fee. If B is a index tracker fund or required to tightly follow a benchmark, it has no option but to hold the shares as they fall.

This is true, and in fact index funds are a major lender of shares for the simple reason that they are long-term stable holders of the shares and therefore ideal lenders of them, since they won't suddenly want them back to sell, most likely.

One other thing to note about the example is that A will owe any dividends paid to B, because those dividends will have gone to C (the buyer of the shares i.e. the other side of the short sale). But B is also entitled to them as the beneficial owner of the shares. Likewise if A borrowed the shares but did not sell them, they would get the dividend but would have to hand it over to B.

Between the fee and the dividends, it can be expensive to short.

Lootman wrote:

Alaric wrote:

PinkPony wrote:How does Person B benefit from this apart from the borrowing fee which must be less than the before and after price difference?

B just gets the fee. If B is a index tracker fund or required to tightly follow a benchmark, it has no option but to hold the shares as they fall.

This is true, and in fact index funds are a major lender of shares for the simple reason that they are long-term stable holders of the shares and therefore ideal lenders of them, since they won't suddenly want them back to sell, most likely.

One other thing to note about the example is that A will owe any dividends paid to B, because those dividends will have gone to C (the buyer of the shares i.e. the other side of the short sale). But B is also entitled to them as the beneficial owner of the shares. Likewise if A borrowed the shares but did not sell them, they would get the dividend but would have to hand it over to B.

Between the fee and the dividends, it can be expensive to short.

But is the dividend really a cost? Wouldn't the share price do down by the dividend amount anyway increasing the shorts gain / reducing its loss.

PinkPony wrote:How does Person B benefit from this apart from the borrowing fee which must be less than the before and after price difference? ('m working on the assumption that Person A wouldn't borrow the shares and pay a borrowing fee if they didn't think they could make a profit bigger than the cost of the borrowing fee.)

Basically, Person B wouldn't lend the shares if they wanted to be able to sell them at very short notice. I.e. they think it's a good idea to hold the shares, at least for the very short term. Person A thinks it's a good idea not to hold the shares. I say "very short" because the standard stock lending agreement does entitle the lender to call in the loan at quite short notice - something like a day IIRC. So if the lender wants to sell at merely short notice, they call in the loan and the short seller has to quickly either close their short or find another lender - short selling is not a game for those who aren't willing/able to react quickly! Equally, if a lender does that at all frequently, short sellers are going to avoid borrowing stock from them, so lending to short sellers is a game for fairly long-term holders...

Anyway, both think they're right, though of course they cannot both turn out to be right. The one who actually turns out to be right wins, the other loses... I.e. they're betting against each other - and because it's the short seller who actively wants the bet and the lender who is merely willing to accommodate the short seller for a fee, the short seller pays the lender a fee.

That assumes that the lender is the actual underlying owner of the shares. If instead the lender is a fund manager, then it's the owners of units in the fund who are betting on the share price rising and the short seller who is betting on it falling, with the fund manager just being a middleman who facilitates it all - and they get paid fees by both sides, i.e. fund management fees and stock lending fees.

Or more briefly and looking at your question in a somewhat different way, I think it is making an additional, unspoken assumption, namely an assumption that the short seller is right!

Gengulphus

Gengulphus wrote: with the fund manager just being a middleman who facilitates it all - and they get paid fees by both sides, i.e. fund management fees and stock lending fees.

Who is ultimately paying the stock lending fees? Is it "buy and hold" investors as the shorting activity presumably dilutes the selling price of investments?

Alaric wrote:
Who is ultimately paying the stock lending fees? Is it "buy and hold" investors as the shorting activity presumably dilutes the selling price of investments?

There may be a short term depression in a company's share price from short selling but ultimately the value of a share is dependent on the profits that a company makes and the stream of dividends generated from those profits.

A short squeeze, forcing the shorters to buy shares, may have the opposite effect of inflating a share price temporarily.

However ultimately short selling has little or no long term effect on the price of shares in a company therefore costs the long term investor little or nothing.

Shorting is a notoriously hard thing to get right without some form of inside information.

Many thanks to everyone who replied. You have clarified my understanding a lot.

Cheers
PinkPony

PinkPony wrote:I have been wondering about a detail in my understanding of short selling. As I understand it:-

Person A wants to short the shares in XYZ plc. They borrow the shares from Person B, pay them a fee for the privilege of borrowing and then sell the shares. Assuming the price of the shares go down, Person A buys back the shares at the lower price, making a profit on the price difference. So far, so good. However, Person A now gives the shares back to Person B who ends up with a holding in XYZ plc that is worth less, possibly a lot less, than it was before the shares were lent to Person A.

How does Person B benefit from this apart from the borrowing fee which must be less than the before and after price difference? ('m working on the assumption that Person A wouldn't borrow the shares and pay a borrowing fee if they didn't think they could make a profit bigger than the cost of the borrowing fee.)

All enlightenment gratefully received.

The way I rationalise it is that there is the "lender" at the end of the chain, who already has the stock which may or may not be overvalued. They taking a business risk, that rather than selling the shares themselves, where they may well make an immediate loss; that they instead lend them out for a fee. When they get the stock back yes it may be worth more, less or the same. And they are free to retain the stock and wait for the next happy punter to come along.