Hard to Borrow Fees: Confusing for Just About Everyone.

Well, the issue at hand is that the market for borrowing stocks can be a moving target.  The operative word here is “market,” and markets cannot be controlled by brokerages or clearing firms.  When there is a large demand to short a stock in relation to the number of shares outstanding, the firms who are actually long the stock get to charge higher and higher rates to loan it out.

To take a step back, someone is only allowed to short a stock (to sell it without being long it already) if they can borrow it from someone who is actually long it.  Assuring they can borrow the required shares is called “getting locate” from their stock loan desk.

When a stock is “easy to borrow,” it is widely known that there is locate and that at the present time there will be no extra hard-to-borrow fees.  At OptionsHouse, if you go to short a stock that is on the easy-to-borrow list, your order will execute as any other order.  Remember, just because a stock is easy to borrow today does not guarantee that it will be easy to borrow in the future.  The market for these stocks can change daily.

When do stocks become “hard to borrow”?  Well, that depends.  Sometimes it is because of a risk arbitrage situation.  For example, if a company is buying (with stock) another company that is pretty close to its size, there is a whole group of traders who “put on the deal.”  They buy shares of the target (the company getting bought) and sell shares of the acquirer short because there is usually a spread.

When the deal closes, it all becomes the same stock, and these traders make the spread.  When the target is really small compared to the acquirer, this probably won't affect borrowers of the acquirer's stock, but if they are a significant part of the acquirer's market cap, the stock will likely become hard to borrow.

This is one way a retail customer might get caught unknowingly.  If he was short the shares of XYZ Corp., and it was easy to borrow, but the company then went out and bought ABC Corp. for stock, the borrow on the stock could change drastically the day after the announcement of the deal.  The stock could go from easy to borrow to extremely hard to borrow overnight.

Another reason stocks become hard to borrow is because of some issue concerning solvency.  Basically, one of a few available hedges for someone holding debt securities on a stock is shorting the equity of that company.  This way, if they lose money on the bonds they own, they would make money on the short stock.  This strategy became really apparent during the financial crisis.

Big offerings of preferred shares can also affect borrowing capability.  This happened in Citigroup (C) stock during the last year.  Before the preferred stock got converted to common stock, investors could buy the preferred and short the common stock and make an attractive return.  The problem was, so many people did this trade so the borrow of Citigroup stock was dramatically affected.

Finally, some stocks simply do not have a big “float,” or stock available for trading by the public.  Much of the company's stock is held by insiders who either choose not to loan out their stock, or the shares are restricted, so they cannot be loaned out at the present time.  When this happens (think internet start-up firms) and the stock is seen as overvalued by a lot of investors, the stock can become hard to borrow.

Okay, so now we have gone through the reasons something could become hard to borrow, but what does that mean for investors?  First, brokerages and clearing firms do not control whether a stock is hard to borrow or not.  There are times when certain brokers have stock available to borrow and others do not.  Usually, they lend their long stock out internally first.

If you want to short a stock and you are with a broker or clearing firm where there is a large long stock position, you probably have better access to it.  However, you are at risk that as soon as the holder of the stock sells it, your situation could change dramatically.

Second, the rate you can be charged for a hard-to-borrow security can vary widely, and it can go to outrageous levels.  In extreme cases, hard-to-borrow rates can go north of 100% on an annualized basis.  It is just a matter of supply and demand.

People who are short have to either pay a huge rate or exit their short positions.  Stocks on the verge of bankruptcy get into this situation often.  People think they only have to be short it for a few more days and the stock will tank on the announcement.  Again, this is not the brokerages or clearing firms trying to fleece their customers; it is the market dynamic in action.

Whether you are a retail customer or a big hedge fund, if you are short stock that gets in one of these situations, the rate to be short can make payday loans seem like free money.    This market resets each night, so the fluctuations are frequent.

How do you know if a stock on your watchlist is hard to borrow?  If you are an OptionsHouse customer and you try and short a stock that is not easy to borrow, your order will be stopped and you will have to call our trade desk.  While this may seem inconvenient, we feel it is very important to reiterate the risks of shorting these stocks, just so we are on the same page.  We can also give you some idea of what the hard-to-borrow rates on the name have been recently but cannot give you any visibility into how they will be going forward.

What does it mean for investors who only trade options?  Obviously, option traders can be exposed to some of these things if they are assigned on calls or exercise puts to wind up short stock.  The other thing is these hard-to-borrow rates are reflected in the prices of the underlying's options.  Puts become relatively more expensive than calls because of this.

Hopefully, this helps you understand what is going on with stocks as they become hard to borrow.  There can be a lot of uncertainty, so it is one of the risks you should consider before going short.

Photo Credit: D'Arcy Norman

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