Shorting stocks - how exactly does it work in the real world?

[diliff]

Hi guys. Me again (sorry) - I've got a question regarding the practicalities of shorting a stock. I know how it works in theory - basically you borrow a stock, then sell it, hoping it will decrease in value, and you can then buy it back cheaper and return to the lender, keeping the difference.

But I don't entirely understand how it works in the real world. From the wikipedia article, I understand that generally the lender is paid a fee to allow stock he owns to be borrowed, but it doesn't say anything about exactly how much the fee is, how it is calculated, how it is paid, when it is paid, etc.

I suppose for the purpose of the question, lets say that I was shorting with IB, as I'm considering opening an account with them. (Does IB allow shorting on the ASX by the way? I've read some old threads about IB suggesting they intended to allow it, but I can't find anything on the IB website about it) What would I need to do to short a stock?

I've seen a couple of live trading videos on youtube in which a trader shorts stock and it seems just as streamlined as going long (ie click a button and voila, you've shorted it), but given that it is quite a bit more complicated behind the scenes, is it really that simple from the end user (trader)'s point of view?

Also, according to the Wikipedia article, the lender of stock retains the right to sell it (which is fair enough. If I owned stock that was diving, I'd want to be able to sell it too!), but how does that affect an open short trade using the borrowed stock??

As I said, it all makes sense in theory but in practise I can see a lot of potential issues.

 

[pattyp]

Oooops, Sorry - Didn't read your entire question... Forget first post

CFDs... You can short long at click of a button... But its usually simulated... eg. CFD providers are Market Makers.


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U borrow someone else’s shares, sell them, buy 'em back lower and give back to the lender... But shorter keep the difference between the sale and buy-back price.

Hope that helps!

Pat

 

[diliff]

CFDs... You can short long at click of a button... But its usually simulated... eg. CFD providers are Market Makers.

Pat

I'm not sure if that is really answering my question as it doesn't seem to be shorting per-se. I haven't looked into CFDs much previously, but as I understand it, they're not even traded on the same exchange, and that would add another layer of complexity that I don't really need.

In suggesting CFDs, are you implying that it can't easily be done on the ASX? From what I've read, its quite simple to do on the NASDAQ, but as with many aspects of the ASX, it doesn't ever seem as simple or as cheap to trade here.

 

[pattyp]

Truly - CFDs are the easiest thing on the planet....

And that’s why so many do their BUTTZ with them... No complexity at all... Complexity is trying to do whatever it is you are hoping to achieve.

R u a broker or large fund...? If not then CFD or Puts/Calls is your best (And really only) bet when it comes to Bearish trading.

Cheers,
Pat

PS. NOT at all recommending CFDs... Hard-core and would probably damage your finances if you don't have a lot of experience (This is an assumption, not at all meaning to disrespect your skeels).

 

[diliff]

Truly - CFDs are the easiest thing on the planet....

And that’s why so many do their BUTTZ with them... No complexity at all... Complexity is trying to do whatever it is you are hoping to achieve.

R u a broker or large fund...? If not then CFD or Puts/Calls is your best (And really only) bet when it comes to Bearish trading.

Cheers,
Pat

PS. NOT at all recommending CFDs... Hard-core and would probably damage your finances if you don't have a lot of experience (This is an assumption, not at all meaning to disrespect your skeels).

No, just an individual trader learning as he goes. My skeels aren't anything to respect, but I've managaged to make a bit of profit in swing trading of late, despite the retreating Aus market. Obviously without the ability to short I've been limited to longs, which have really only been profitable in a few sectors, so being able to short would essentially double the trading options available to me.

I'm not saying that CFDs are inherently complex - I'm sure they are very simple to execute. The complicated thing is not being able to take longs/shorts on the same stocks on the same exchange at the same time as it appears to be possible to do quite easily on NASDAQ. It makes day trading more difficult as far as I can see.

My trading platform has been pretty basic thus far - Quotetracker using a Westpac Broking feed (which isn't really streaming real-time, just snapshots every 20-30 seconds or so), and as far as I can see, it only works with the ASX.

I'm looking to switch to IB for more flexibility/superior platform, but it still doesn't solve the issue of having to work with two different exchanges to do regular long trades and CFD shorts.

 

[AlterEgo]

Hi Diliff,

IB do allow shorting of ASX stocks, but the range they have available for shorting is very limited.

Like you, I have also been looking in to what my options are for shorting ASX stocks. I have made some pretty good gains in the past financial year, however being only able to trade the long side of the market has really limited my opportunities, and I've had to sit in cash on the sidelines for a substantial part of the time.

Anyway, after examining all my options, I ended up deciding on opening a DMA CFD account with FP Markets. I should be up and running with them very soon.

 

[tech/a]

how exactly does it work in the real world?

Brokers who allow shorting,source shortable stocks.
But thats about all I know.
Specifically I would like to know the following.

If you short a stock,you are borrowing it,what if the owner of the borrowed stock wants to sell it during the time you have borrowed it?

I understand you pay dividends when you borrow the stock,but who gets the dividend issued by the company---the owner? So there are 2 dividends running around one paid by the borrower and one buy the company.

How is it benificial for the owner of a stock to borrow it to someone?
Ive not seen a fee fly out of my account when I have shorted.

 

[Timmy]

Anyway, after examining all my options, I ended up deciding on opening a DMA CFD account with FP Markets. I should be up and running with them very soon.

You are right AlterEgo, CFDs are by far the easiest option for shorting ASX stocks, really worth looking into Diliff. In what way are you thinking using DMA CFDs is going to add complexity to your trading? Also, shorting the physical stock may add more complexity than using a DMA CFD?

 

[Timmy]

Specifically I would like to know the following.

If you short a stock,you are borrowing it,what if the owner of the borrowed stock wants to sell it during the time you have borrowed it?

Your broker may ask for the stock back from you. So you may have to cover the short when you don't want to...

I understand you pay dividends when you borrow the stock,but who gets the dividend issued by the company---the owner? So there are 2 dividends running around one paid by the borrower and one buy the company.

The company pays the dividend to the person registered as the owner of the stock, that is the person you have borrowed it from. The person you have short sold the stock to also wants the dividend, of course 'cause they have bought the share, so you, the shorter, are obligated to pay the dividend to this person. So yes, 2 dividends running around. The cost to the shorter of paying the dividend is offset to an extent (usually, but not always, close to 100%), by the dip in the share price when it goes ex-dividend.

How is it benificial for the owner of a stock to borrow it to someone?
Ive not seen a fee fly out of my account when I have shorted.

When an owner of a stock lends it someone for shorting there is normally a fee payable (usually expressed as an 'interest payment') to the lender, and paid by the borrower. How much, when, in what form etc. Don't know, have to check with the broker you are shorting through. Shorting an equity CFD, though, usually results in a payment being made to the shorter.

 

[Timmy]

Just re-reading some of the earlier posts. About CFDs being dangerous and maybe damaging to your finances ... there are two dangers in equity DMA CFDs that are not present in share trading.

One is there is a credit risk. A trader trading in CFDs has a contract with the CFD provider and is not covered by the insurance he or she would have if dealing in ASX shares through a stockbroker (the guarantee fund). So the danger is a CFD provider may go out of business leaving outstanding contracts. I don't know of any CFD providers who have left traders out of pocket by going out of business. Dealing with a large, well capitalised dealer in CFDs is going to minimise the risk (but never entriely remove it).

The other risk is normally to do with the use of leverage. Leverage is offered over physical shares (for example margin loans) but the leverage, and more of it, on CFDs is much easier to obtain. This is not really a risk because it is up to the individual trader to use leverage or not. There is NO requirement to use leverage when trading CFDs so in a sense this is not an added risk at all.

 

[IFocus]

I'm looking to switch to IB for more flexibility/superior platform, but it still doesn't solve the issue of having to work with two different exchanges to do regular long trades and CFD shorts.

After trading CFD's since they were 1st introduced to Australia its only this year I moved to IB.

IB have around 120 stocks available to short on the ASX if that is not enough then simply switch on the US market and you have more than 10,000 stocks to short.

The advantage of IB over local CDF DMA providers (any lcaol broker in fact)is the cost of brokerage and its very significant.

As for shorting via IB you place a sell order and if filled you are short, as simple as going long.

Via IB also you have access to a massive range of order types the Australian brokers are stone age in comparison.

IB also have a simulator that works just like the real thing allowing you to work out the oder types, trading method etc

Good explanation Timmy on shorting


Hope this helps

 

[Timmy]

Thanks iFocus - that is great info on IB, they certainly have some significant advantages over the locals (lower bro being a BIG one!). What sort of leverage do they allow on shortable stocks?

 

[Wysiwyg]

One thing to take note of is company dividend pay dates.I shorted the Aussie 200 and held overnight.There were over $600 worth of company dividends paid on the day which (because I went short) were deducted from my account.You see, it was my newbie mistake.Ouch.ASX/DVD = A$-687.20

 

[IFocus]

Timmy around 2/1 over night 4/1 during open market hours the leverage is not as good as CFD's and its the one disadvantage I miss. Having said that I don't anymore.

The order types are great I can set a stop limit order to enter a position and at the same time setup the stop and profit target orders, once the entry is triggered the others orders will then become active waiting.

After using the simulator I tried small positions in the US taking $5K position size the brokerage was $1 entry.........I had to check to see if there was a mistake LOL

IB isn't for everyone like they say its made for professional traders. It has taken me awhile to work my way around the platform and to some degree still a work in progress but for me very worth while. Its got to be worth 2% to 5% maybe more to the bottom line return to my trading account.

For newer traders starting out if you are serious about this being a long term project then I would recommend using IB.

Back to the Simulator, IB has a great Simulator it is perfect for testing I use it all the time, I do go on about testing / paper trading but if you don't then IMHO you are a mug punter nothing more.
Without testing a significant sample you have no idea about your understanding of the method you hope to deploy trust me you have no idea none, zilizh, zero, nothing, nada.
Testing is the single biggest reason I became profitable over the longer term and remains so, not my trading method, my skill, market knowledge (you get the picture).

Also for the newer trader brokerage and slippage can often be the difference between break even and making loss's as they tend to take smaller size positions and in this current market thats a prudent action any way.(actually standing aside and wait for a trend is the prudent action)

If you work the IB method of charging brokerage then you can reduce this exposure.

Hmmm turned into a bit of a rant as always hope this helps.

 

[MichaelD]

How is it benificial for the owner of a stock to borrow it to someone?

When shorting real shares (as opposed to shorting with a market maker), the owner will be a large fund or the broker themselves. They will have a long term bullish outlook for the share, as opposed to the shorter time frame outlook you will have. They lend you the stock for a lending fee - that is their benefit in the transaction. They still own the share, but they've made a bit of money on the side loaning it out.

Typical fees would be around $100 per position.

If they want to sell the shares whilst you have borrowed them, you'll be forced to close your position and give them the shares back (unless the broker can get another loan of shares from somewhere else).

 

[diliff]

When shorting real shares (as opposed to shorting with a market maker), the owner will be a large fund or the broker themselves. They will have a long term bullish outlook for the share, as opposed to the shorter time frame outlook you will have. They lend you the stock for a lending fee - that is their benefit in the transaction. They still own the share, but they've made a bit of money on the side loaning it out.

Typical fees would be around $100 per position.

If they want to sell the shares whilst you have borrowed them, you'll be forced to close your position and give them the shares back (unless the broker can get another loan of shares from somewhere else).

That makes sense, but from what other people have insinuated, there is no fee associated with shorting via IB?

Also, the fact that the owner could sell at any moment is a significant issue if you're short. If you have an open position, you simply cannot have it taken away from you midway - thats quite ridiculous.. who would agree to such a thing, and pay $100 for the privilege? Well, I suppose those who think that they could still make a buck despite the risks, but I'd want a bit more assurance that my trade would stay open until I'm satisfied (margin calls etc aside, obviously).

I've learned a lot about 'how it all works' though. Much appreciated. I'm definitely going to have to get an IB account, if nothing else than for the lower brokerage and superior order placement.

 

[Timmy]

IFocus, thanks v. much for the response, appreciate the info. A lot of good people recommending IB now, and $1 bro for $5K...wow!

Tks again

 

[MRC & Co]

That makes sense, but from what other people have insinuated, there is no fee associated with shorting via IB?

Also, the fact that the owner could sell at any moment is a significant issue if you're short. If you have an open position, you simply cannot have it taken away from you midway - thats quite ridiculous.. who would agree to such a thing, and pay $100 for the privilege?

Some excellent responses here guys. I had no idea how stocks were sourced for shorting either or exactly how these dividend payments worked.

I don't pay $100 fee for shorting via IB,

Agree with Ifocus on IB.