What’s short selling and stock lending?

Posted: August 01, 2008

These techniques allow investors to make money even when share markets are falling.

The traditional way of investing in the share market is to buy the shares of good companies and hold them for the long term. You benefit from the payment of dividends and the appreciation of the share price over time. History has shown that over the long term, the share market has outperformed the other major asset classes. This style of investing is commonly known as ‘long only’ investing.

Whilst share markets perform well over the long term, they are also volatile. There will be periods (like early 2008) where share prices fall. In these circumstances, a ‘long only’ investor will post negative returns.

The technique of ‘shorting’ involves selling shares you do not own and then buying them back again when the price has fallen. In this case you make a profit when the share price falls – the opposite to the long only investor.

‘Stock lending’ allows a shareholder to earn an extra fee by temporarily lending their shares to an investor who wants to employ a short selling strategy. The lender has a right to receive the shares back in the future and keeps any dividends paid by the company.

Of course, ‘shorting’ can be a risky strategy because the share price may not move downwards as expected. A ’long only’ investor could potentially lose all his capital while there is no limit to the losses that could be incurred through shorting (as there is no set limit to the upward movement in the price of a share). Sophisticated investors may choose to protect themselves in this instance through the use of various derivative contracts.

Those in favour of stock lending argue that it helps to ensure share prices reflect the real value of the company. A share price is determined by buyers and sellers who are trading based on the knowledge they have about the economy and the company’s prospects. So in theory more buying and selling should lead to more accurate pricing of shares.

Those who are not in favour simply argue that you should not be able to sell something that you do not own. You either own the asset or you do not. Like most things in life there is usually more than one point of view.