Hard to borrow
http://community.tradeking.com/members/optionsguy/blogs/37909-why-do-stocks-get-%E2%80%9Chard-to-borrow%E2%80%9DQ: Why do stocks get "hard to borrow"?
A: Short selling involves borrowing shares of stock you don’t hold yourself, selling them, and then hopefully buying the shares back later at a lower price. But when lots of short sellers try to borrow stock simultaneously, a “hard to borrow” situation can emerge. This post explains the dynamics of this scenario and how it can impact your trades.
My latest Grab Bag post,
Speedy options assignment, explained, addressed a TK client who was getting assigned early as an options seller at a mysteriously fast rate. As that post explained, market makers getting hit with a “hard to borrow” stock situation might well have been the reason. Several of you wrote in to ask for a fuller explanation of how “hard to borrow” conditions emerge, so here goes…
What’s short selling?First, let’s briefly summarize short selling – since it’s often an influx of short sellers on a particular stock that creates a “hard to borrow” situation. Short selling involves “borrowing” shares of stock you don’t hold yourself, selling them, and then hopefully buying the shares back at a lower price. The short seller then returns the “borrowed” shares to their original owner, having pocketed the difference between selling-high and buying-lower.
(Of course, short selling can go seriously awry if the stock doesn’t drop in price as you’d predicted. If that happens, short seller can be exposed to potentially unlimited losses – so it’s not a move to be taken lightly.)
Now let’s compare short selling in the stock market to a bank. In the simplest form, a bank makes money by taking money deposited in savings accounts and lending that same money out to other customers at a high interest rate so they may be able to buy a house, a car, etc. The bank must keep so much capital on hand just in case you stop in and say you would like to close your account and withdraw your money.
A similar balancing act happens in the brokerage world for shorting a stock. Clearing firms, who handle most of the back-office operational paperwork for brokerage firms, typically hold all stocks for the margin customers of the brokerage firm. When a trader wants to sell a stock short, the clearing firm lends that person the shares to be able to do that. Much like the banks described above, if a clearing firm is going to lend out the shares, they have to simultaneously make sure there are enough on hand, in case a person that is long the shares actually wants to sell them.
When the number of shares the clearing firms hold gets to a certain percentage shorted, the firm may activate policies to make the stock harder to borrow, thus maintaining their own supply. For example, they might specify that nobody else can short it without special permission. They might even “call back” short shares outstanding, so that those who have borrowed them for short selling basically have to give them back immediately.
The resulting scramble in a “hard to borrow” situation can make it harder for market makers to hedge positions – specifically, when the hedge they’re looking to do involves selling the stock short. This may force market makers to act against the norm. One thing it can cause them to do is to exercise in-the-money calls they’re holding well before expiration.
This move serves two purposes: first, it enables them to lay hands on shares immediately if they are required to cover their shorts ahead of plan. Second, this move also gets the position off their books, that way they don’t have to worry about hedging it. (
My previous post explains more about that logic.)
As you can see, understanding the mechanics behind market activity is more than academically interesting. Understanding the dynamics of each of these market players can help you better anticipate their moves under certain circumstances – and plan your own moves more intelligently, too.
