Securities lending

Shorting, or short selling, is when you sell shares you do not own, but shares you have borrowed.

How short selling works:

You borrow a certain number of shares (by paying an interest rate/rent). You then sell the borrowed shares at that day’s share price. You do this because you believe the share price is higher now than what it will be when you have to give them back.

If you are correct, and the price drops before you have to give the shares back, you can buy the same quantity cheaper than what you sold them for before returning them. You thereby profit from the price reduction.

Shorting example

You borrow 100 shares and sell them immediately at that day’s share price of NOK 50. In total you receive NOK 5 000.

You have an agreement to return the 100 shares within 14 days.

After 10 days, the price of the shares you borrowed has gone down to NOK 40. You then buy 100 shares for NOK 4 000 and give them back before the deadline.

After your short sale you’re NOK 1000 in profit (minus the borrowing costs)

If you guessed incorrectly about the share’s price movement, the result would have been the complete opposite.

Read about risk in the next question.

When short selling, you can lose unlimited sums

The reason we say ‘unlimited sums’ is because, in theory, the price of the share you have borrowed can rise infinitely before you are able to buy back the number you have borrowed. Changes can happen quickly in the stock market!

The risk involved in short selling is much higher than with traditional equity trading. You should know what you are doing.

With normal equity trading, where you buy a security and bet on a price increase over a longer period, you only risk losing the amount you have actually invested (if the price falls to 0). This is a risk that is easy to relate to.

Short selling is riskier. Read below:

Short selling example

An investor borrows 10,000 shares from DNB Markets. The price per share is NOK 10, but the investor thinks the price will drop substantially in the coming days. He therefore borrows and sells in the market at that day’s price, NOK 10 per share. He receives NOK 100 000.

His ‘bet’ is that the share price will drop to around five kroner in the coming days, he can then buy the same amount for NOK 50 000 before the shares need to be given back.

Suddenly, new information reaches the markets causing the price of the share to rise significantly. Over the course of a couple of hours, the share price rises to NOK 30! The investor is now nervous that the loss will become even greater. He rushes to buy 10,000 shares for NOK 300 000 in order to return the 10,000 shares in time. This is called ‘closing a short position’.

His loss is NOK 200 000. Four times the profit he expected to make.

We make a key distinction between two types of short selling, covered and naked. The former is when an investor selling shares actually has access to them at the time of the sale. In the securities market, this usually means that the investor has borrowed the securities from another investor before he sells or has a secure agreement about being able to borrow them. In this way, covered short selling will guarantee that the investor actually can deliver the securities he’s selling.

In Norway, it is only legal to do covered short selling. Ref. Norwegian Securities Trading Act Section 3-14.

Naked short selling is when the investor does not have access to the securities at the time of the sale but plans to obtain these at a later stage before returning them. This can be done in all markets where the delivery date for the asset is later than the date of the sale. For the stock market, the delivery of the shares (also called ‘settlement’) is often two days after the sale. The investor must buy or borrow the shares, so he has them ready for delivery for the sale he first made. Should the investor have sold shares he fails to deliver, he can be held financially and legally liable.

The lender is often a broker, a bank or large institutional investors.

Loans can also be organised through loan pools to streamline the market through lenders and borrowers.

The lender must be aware that there are some disadvantages to lending his shares. Depending on the conditions of the loan, the lender may be limited in how quickly he can demand to have the loan repaid. In the meantime it is not possible to sell the shares or vote with them. Any dividend will be paid to the holder of the shares, but the lender will be compensated for this. The lender may also have a counterparty risk with borrowers that go bankrupt and cannot give back the securities. To compensate for these disadvantages, the borrower must pay interest to the lender.

DNB Markets lends shares.

Go to the securities lending page here.

In finance, the term ‘hedging’ means investing with the objective of removing or minimising the risk of another investment. In simple terms, hedging works as insurance for the investor.

So hedging reduces the overall risk in a portfolio. At the same time, hedging means that you earn less. You can compare this with insuring your car. The actual insurance policy will cost a little, but you may consider this worthwhile if the car is stolen or you crash it.

Simple example of hedging

You invest in Tesla. The car industry is cyclical, which means that Tesla sells more cars in economic uptrends and fewer when times are bad.

A way of hedging here would be to buy shares in something that does well when the economy is generally going down. The groceries industry is such an industry. If the investor in Tesla also buys shares in groceries, the average value of the portfolio will be better maintained through downturns as well.

Read more about hedging on Investopedia