A picture of an old shares certificate.Bart Sadowski/Getty Images/iStockphoto
The Question:
I am constantly hearing about selling short, sometimes as large as 25 to 30 per cent of the outstanding shares of a stock. My question is: why would anyone who owns a stock lend the shares to another person who has the intent of driving down the value of the owner's investment? I would think the small amount that they get would not offset the reduction in the value. Further to this, can my shares be lent by my broker without my approval?
The Answer:
Shorting a stock is not quite as simple as it sounds. If you want to short sell a stock, your broker needs to call his or her firm's loan desk to see if the shares are available for lending. Shorting is more typical with higher priced and more liquid securities, and less frequently done for speculative penny stocks. If the firm does not own it in their own portfolio they have to attempt to borrow the stock from other firms. There is a lending fee charged by the lending firm and the cost varies based on a number of factors. Only if the shares can be borrowed can you, the client, short sell the stock. If you short sell a stock you do not have the influence to "drive" the stock price down, other than putting selling pressure on that security. It is typically that you are of the view that a stock is overvalued and will decline in price creating the opportunity for you to buy the shares back at a lower price than what you sold it at. This in turn is how you make a gain. If the stock you short sell pays a dividend, you are responsible for paying the dividend rather than if you owned the stock and received it.
As a client of a firm, your shares cannot be lent out to someone who is looking to short sell. Shares are held in trust for each client and are kept on separate books.
The most significant risk to a short-seller is that a stock, theoretically, can go up to an infinite price. Your risk then is infinite; whereas if you buy, or go long, a stock, your maximum loss is only what you paid for it.
If you are interested in capitalizing on a stock that you believe will go down in value, I suggest you further educate yourself with trading options. Options are derivatives that may be a suitable alternative to short selling. Options are complex and I only usually suggest them for the most experienced investor.
Nancy Woods is an associate portfolio manager and investment adviser with RBC Dominion Securities Inc. Visit her website www.nancywoods.com or send an email request to asknancy@rbc.com. You can also send your questions to asknancy@rbc.com.