The Cost of Short Selling - Term Paper Example

?The cost of Short selling Table of Contents Table of Contents 2 Introduction 3 Short selling costs 3 Capital gains tax and short sales 6 Other costs6 Proxies for short selling 7 Conclusion 10 Introduction In a short sale an investor sells securities that he does not own. A short position is established when an investor borrows a stock and sells in the market. One can square-off the position by purchasing the stock on a later date to re-pay the stock loan. By way of short sale the seller can make a gain if the price at which the stock is bought is lower than the sale price. A short sale, in general, requires loaning a security and comprises two parties- the borrower and the lender. Stock lending can take place directly or through intermediate agents. The fee for lending is a factor of market demand and supply; low supply or high demand raises the fees. It is said that short selling also influences the market price of a stock; for this reason the regulatory bodies restrict short selling in times of depressed market conditions. Another argument that goes against short sale is the high costs associated with it in the form of margin interest, commission and bid/ask spread. Other than these short selling is also exposed to dangers like unlimited losses, uptick rule etc. Other proxies are available in the market such as options that can replicate short selling and are also said to be less costly. Short selling costs Collateral and margin requirements- Short selling a stock is the opposite of going long on a stock in a “margin account”. An investor borrows the shares from the brokerage firm. As the seller does not own the stock he has to furnish collateral such as T-bills or cash (AIMA Canada, 2007). These serve the margin requirements of short selling. The amount which the investor has to deposit in the account at the point of initiation of sale is known as ‘initial margin’. The amount that an investor must maintain in the account after the initiation of trade is referred as “maintenance margin”. As per the requirements of the Federal Reserve Board, at the time of initiation of sales an investor has to provide 150 percent of the total proceeds from short sale. For instance, if 1000 shares are sold short at $9, then the amount of initial margin required is 100 percent of sale proceeds together with an additional margin of 50 percent i.e. a total of $13500 (Investopedia, 2010). Bid and ask spread- In a stock quote there are two prices- bid and ask. In the case of a short sale an ordinary investor sells the security at the bid rate. For this kind of investor the broker transmits the order to the stock exchange. At this point the market maker or specialist sells the stock and makes a profit equivalent to difference between the bid and ask rate referred to as ‘spread’. Suppose the bid and ask of Microsoft is $25.95 and $26.05 respectively. Then on a short sale the market maker will enjoy a spread of 10 cents. The profits earned on each trade may be small but the market maker can make huge profits in the case of bulk trading volumes. The amount shelled out as ‘spread’ is borne by the ordinary investor. The ordinary investors fail to realize this and place trade using market orders. In this kind of trade an investor may not get a good return on trade. Margin interest- Most of the firms charge an interest on the amount of securities shorted in an account. Going by the low rate of interest this may appear to be small but this can in due course add up with time. Suppose if an investor shorts $8000 worth of security ABC and the interest charged on the account is 6 percent then the investor will have to pay $480 as fees for that year. In the case of highly liquid stocks an investor can also ask for waiver of margin interest. Commissions- The amount paid as commission varies as per discount brokerage firms and full service. An investor has to pay a higher rate of commission in the case of full service brokerage on account of the personal counselling and guidance. But this may not prove to be always fruitful as the brokers may not possess good knowledge about shorting. In such situations the investor can rely on the services of discount brokers (Taulli, 2004, p. 26). Source: (Mayo, 2007, p. 69). Dividend payments to lenders- When an investor borrows a security its title passes on to him. This means that the borrower will enjoy all the benefits of ownership except with the coupon or dividend limitations. Under agreed upon terms the borrower has to pass on any dividend or coupon payment to the stock lender. This is commonly referred as “manufactured dividend” (AustralianSuper Pty Ltd, 2008). Suppose an investor shorts 100 shares of a Tesco Plc and after the sale the company pays a quarterly dividend of ?0.20. In this case the company sends the dividend of ?20 to the individual who buys the shares. However, the lender of the stock expects to get his share of dividend. Therefore the short seller has to compensate for the dividend to the stock lender. In the records of the company person who buys the stock from the short seller is the owner so there is no reason as to why the company will make dual payments. So the short seller has to pay $20 dividend to the lender of the security. This is done automatically by the broker who debits the amount of dividend of ?20 from the account of the short seller or borrower and credits the same to the lender’s account. So the amount of dividend also becomes a cost to the short seller. However this may not wash off all the earnings as the price of the share declines by the amount of dividend. For this reason it is said that dividend payment does not have any significant impact on the position of the short seller (Mayo, 2007, p. 69). Capital gains tax and short sales Taxes are applied on short selling transactions to prevent the following- Deferring the gain to some later period when one can sell short and retaining the appreciated position on the stock. This form of short sale is referred as “sale against box”. Conversion of short term gains to long term gains. Converting long term based losses to short term. The gain realized on short sale is generally reported in the year when the sale is closed i.e. when the replacement stock is delivered to the lender. However if at the time of execution of the short sale an investor holds an “appreciated position” in the stock or acquires an identical stock to close his short sale position, this is treated as ‘constructive sale’ and is to be reported in the year of such sale although the delivery may happen at a later date. The nature of the gain or loss i.e. whether it is long term or short term depends on the investor’s “holding period for the property” that is delivered in the hand of the broker to square off the short sale position (J. K. Lasser Institute, 2007, p. 208). Other costs Other than the above costs a short sale transaction is also exposed to dangers like uptick rule, unlimited losses and buy in short squeeze. Uptick rule- It may happen that the investor is not able to buy the stock when its price declines. This is referred as ‘uptick rule’. There is a perception that a stock market fall is aggravated by short sellers. To curb this regulatory authorities restrict the short sale of stocks with falling prices. This may make it difficult for the short sellers to square-off their position. Unlimited losses- On a short sale of 1000 shares of $10 per share, the highest amount of profit that a seller can earn is $10000. This will happen if the stock price reduces to zero. But the amount of loss that may arise is unlimited. It is often said that the possibility of making loss on short sale transaction is more than the profit. On a long position the maximum loss that may be incurred is the amount spent on purchasing the security. However in a short sale the loss that an investor may incur is infinite as theoretically there is no maximum price for a stock (Taulli, 2004, p. 28). Short squeeze- This is a challenge faced by the short sellers. This happens when the outstanding position on short sales is significantly high. In this situation any positive market sentiment forces the short sellers to square-off their position simultaneously. This can push up the stock price significantly in a short time period. Proxies for short selling A short position is initiated when the investor anticipates the stock market to fall i.e. if he expects a bearish trend. Other than short sale there are other ways by way of which a trader or investor can capitalise on his market predictions. Option is one way by way of which an investor can gain from an anticipated bearish movement. Short selling a stock is a way by which the investor can gain from any downward stock predictions but this has certain limitations. Like a short sale trade requires sufficient amount of capital investment and technically bears unlimited risk. Options offer a solution to all the above shortcomings. Buying an option requires an initial outflow in the form of ‘premium’ which is much less as compared to capital outflow in the case of short selling which involves margin maintenance. For all these reasons short sales are considered to be a costly affair resulting in limited volume of such transactions on stock exchange. The reasons for the escalating costs of short sale dealings have been explained. A short sale order is placed by a short seller to the broker. The latter borrows the requisite securities from the customers having margin accounts with his firm or from other institutional stock lenders or brokerage firms. For this the borrower has to furnish collateral of 100 percent of security’s cash value. Here again factors like supply of security determine whether the lending broker can allow any rebate on the collateral interest to borrowing broker. This may happen only if the securities under question are easily available i.e. have high liquidity levels whereas if the securities are scare in supply then the borrowing broker may have to pay some amount as ‘premium’. As all these costs are eventually borne by the short seller the process becomes very costly thus explaining the limited trading volume of such transactions. On NYSE (New York Stock Exchange) short selling accounts for only 8 percent of the total trading volume of the exchange. Given the high costs associated with short sale it fails to draw the attention of the ordinary investors. This has given rise to the assumption that there is practically no short sale in the market. There exist financial products that can act as a close substitute of sort sale and are also less costly. If a country has an active option market then ‘going long on put’ or ‘going short on call’ can create a position which is identical to short selling. The only significant difference between the two is that in the case of options there are no dividend payments and unlike short sales, options have a pre-determined date. According to Figlewski & Webb (1993) most of the trading carried out in the option market is actually a way of taking advantage of bearish stock movement like short selling. Selling index futures is also one way of replicating short sale (Allen & Gale, 1994, p.81). Acquiring a put option- Buying a put option gives the same benefit as short selling a stock. This gives the ‘option to sell’ and can be treated as equivalent to short sales if the investor already holds identical securities at the point of buying the put option. The advantage of put is that the initial outflow is less and moreover there is an option to sell without any obligation i.e. if the market prediction goes wrong then the investor can safely let the option lapse. Unlike short selling the downside risk in a put option is limited to the amount of premium paid but the upside gain is similar to that of the short stock. If an underlying stock is held for less than one year at the time of buying the put option any resulting gain on put can be shown as “short term capital gain”. The same is true if the stock is bought after the purchase of the put option. But the rules of short sale are not applicable if the investor buys a put option and buys a stock which is covered by this put. Suppose an investor buys 100 put options of 3 months maturity $50 and the put premium is $2.00. This will result in an immediate outflow of $200. This will give the option buyer the right to sell 100 shares at $50 for the next 180 days. During this time if the price of the stock drops to say $45 then the buyer of the put option can sell short the shares at the pre-set rate of $50. The profit earned by him is the difference between the exercise price and current market price of the stock after deducting the amount of premium paid on buying the put. Selling a call option- Selling a call option is a proxy for short sale of the underlying asset (DeMark & DeMark, 1999, p.11). This type of position is undertaken when an investor anticipates the stock price to fall i.e. if he predicts a bearish trend. The liability of the individual shorting the call is technically unlimited like short sales but it offers some advantages over short selling. Like the call seller will receive an initial inflow equivalent to the ‘call premium’. Basically he anticipates that the stock price will fall below the ‘strike price or exercise price’ on the expiry of the option. Therefore the call option will lapse with the call seller pocketing the option premium. The inflow of the call seller is limited to the amount of premium received by him i.e. his upside risk is limited however the downside risk of this strategy is immense. Suppose an individual sells 1000 call options on Stock of Electronic Arts Inc (ERTS) listed on NASDAQ, of 3 months maturity at a strike price of $16 with a premium of $0.10 each. Then the call premium received by the call seller will be $100. If on the date of expiry the price of the share drops to $10 then the buyer of this call will not exercise the option and the call seller will make a profit. Bear put spread- This strategy is a good substitute of short selling a stock or buying a put option. This involves buying a put option at a higher strike price and selling an equivalent number of put options of similar maturity at a lesser strike price (Rangantham & Madhumathi, 2009, p.427). If the investor anticipates a fall in the market to be moderate then the bear put spread can act as a good bet (The Options Industry Council, n.d.). Suppose if the investor is moderately bearish about the market then he can buy a put option say at a strike price of $50 and sell a put option at a lower strike price say $40. The main motive of this strategy is that it lowers the net premium outflow. Here it is said that the investor is bearish at the point $50 i.e. he expects the prices to go below this level however he is bullish at $40 i.e. he does not expect the decline to be so steep. If the premium received by him by selling the put at $40 is $1.00 then the premium inflow will be $100 (for 100 put) and the premium outflow is $200 for buying $50 put therefore the net outflow in this strategy will be less as compared to a plain long put. The net outflow is $200-$100=$100. This is better as compared to simply going long on put as it lowers the trading cost from $200 to $100. The bear put spread ensures that the probability of profit is high as compared to simply shorting a stock or buying a put. This can be an outstanding move if the market is not expected to decline significantly or in the case of market uncertainty (Kaeppel, 2009). The only limitation is that the profit potential is limited to the difference between the two strike prices i.e. $50 and $40 after subtracting the net premium outflow. On the other hand the profit potential of short selling is high but the probability of profit is low as compared to the bear put spread. Selling index futures- Another alternative of short sale is selling the futures having index as the underlying. Even though this requires strict margin maintenance here the amount of capital investment is less as compared to short sale Conclusion Short selling improves market efficiency by discounting the negative news in the stock prices. This helps in preventing asset bubbles or stock overprices. However short selling has a number of constraints like the dividend reimbursement. Here the short seller has to compensate the stock lender with the full value of the dividend making him a ‘virtual owner’ of the stock. Even though it is argued that the price of the stock falls after a company pays dividend but this drop is considered to be incomplete (Thornoc, 2010). Therefore the process of short sale becomes very costly for an ordinary investor relying on the services of the broker. There are a number of alternatives like options or index futures which can act as a proxy to short selling. By taking a suitable position in these instruments an investor can capitalise on any anticipated fall in the market by shelling out lesser amount of capital i.e. on a reduced cost base as well as a lower level of risk. Reference AIMA Canada. (2007). Mechanics of Selling Stock Short. An Overview of Short Stock Selling. Retrieved on 5 January, 2011 from http://aima-canada.org/doc_bin/Overview%20of%20Short%20Selling-v2%20_2.pdf Allen, F. Gale, D. (1994). Financial innovation and risk sharing. MIT Press. AustralianSuper Pty Ltd. (2008). What is ‘short selling’?. Super Topics. Retrieved on 5 January, 2011 from http://www.australiansuper.com/resources.ashx/formsandpublications/635/File/CDF44D140D3727A4ED6330C6558CCEB3/Securities_lending_and_short_selling_Sep08.pdf DeMark, R.T. DeMark, R.T. (1999). DeMark on day trading options: using options to cash in on the day trading phenomenon. McGraw-Hill Professional. Investopedia. (2010). What are the minimum margin requirements for a short sale account. Retrieved on 5 January, 2011 from http://www.investopedia.com/ask/answers/05/shortmarginrequirements.asp J. K. Lasser Institute. (2007). J.K. Lasser's Your Income Tax 2008. John Wiley and Sons. Kaeppel, J. (2009). Bear Put Spreads: Alternative To Short-Selling. Forbes.com LLC. Retrieved on 5 January, 2011 from http://www.forbes.com/2009/02/13/puts-spread-options-personal-finance-guru-insights-0213_investopedia_options.html Mayo, B.H. (2007). Investments: an introduction. Cengage Learning. Rangantham, M. Madhumathi, R. (2009). Investment Analysis and Portfolio Management. Pearson Education. Taulli, T. (2004). What is short selling?. McGraw-Hill Professional. Thornoc, R. J. (2010). Conclusion. The Effects of Dividend Taxation on Short Selling. Retrieved on 5 January, 2011 from http://sites.som.yale.edu/accountingconference/files/2010/02/Thornock-Jacob-paper.pdf The Options Industry Council. (No Date). Moderately Bearish. Options Strategies: Bear Put Spread. Retrieved on 5 January, 2011 from http://www.optionseducation.org/strategy/bear_put_spread.jsp Bibliography Black, R. Krueger, P. (2005). Getting on the moneytrack. John Wiley and Sons. Black Enterprise. (1995). Selling Short, an Adventure in Risk. Vol. 25, No. 9. Earl G. Graves, Ltd. Retrieved from http://books.google.co.in/books?id=A10EAAAAMBAJ&dq=short+selling+costs&source=gbs_navlinks_s Brigham, F.E. Ehrhardt, C.M. (2008). Financial management: theory and practice. Cengage Learning. Fabozzi, J.F. (2004). Short selling: strategies, risks, and rewards. John Wiley and Sons. Staffi, C.A.P. Sigurdson, K. (2008). Price Efficiency and short selling. IESE Business School. Retrieved from http://www.iese.edu/research/pdfs/DI-0748-E.pdf Stefanin, F. (2006). Investment strategies of hedge funds. John Wiley and Sons. Read More