Regular readers of the Angel One blog will be aware that we often talk about the many different dimensions of financial markets. In this blog, we will talk about a trading practice that is not commonly known. This practice is usually popular among experienced traders who like to take on more risk than usual. The practice is called Stock Lending and Borrowing. In this article, we will understand what is stock lending and borrowing by discussing their meaning. We will talk about what sort of stocks a trader can lend or borrow, the similarities and differences from borrowing/lending other types of capital assets, why the risk in borrowing the stock is bigger than in simply buying the stock, and other interesting information.
What is stock lending and borrowing(or Securities lending and borrowing)
The borrower tends to be an individual who expects the stock price to plummet in the near future. The lender is usually a High Networth Individual (HNI) who has no short-term plans to clear his holdings. Let’s look at the incentives of both the players in a security lending and borrowing scheme.
A High Networth Individual does not want to sell his stock. He believes that his current position will give him long-term returns. However, this does not mean that his stock holdings have to be an idle assets with no short-term returns. He can activate the earning potential of his stocks by lending them to a trader and charging an interest rate. This interest rate is referred to as a premium.
The borrower, on the other hand, wishes to turn the expected crash in the stock’s value in the near future into profits. He wants to engage in a practice called Short Selling. Short selling is the opposite of taking a long position. A trader takes a long position in a financial asset when he believes that its value will go up. On the other hand, if a trader’s analysis is telling him that the stock’s value is about to depreciate, then he can consider taking a short position. There are three steps in a short position trade:
- Borrow: The trader needs to borrow the relevant stock from someone who possesses them. For this, the borrower will need to pay an interest rate.
- Sell: In the next step, the borrower will sell the borrowed stock in the open market.
- Buy: If the borrower’s prediction turns out to be right, he can expect the price of the stock to drop. Once this happens, he can buy back the same stock from the open market at a discounted rate. The price at which he sold the stock will be greater than the price at which he buys it back. The difference will constitute his gains from the trade.
- Return: The borrower will simply return the stock that he borrowed.
Is lending or borrowing stocks like lending or borrowing any other asset?
Yes and no. There are similarities like the borrower must pay an interest rate, and return the asset before the tenure ends.
There are differences as well. The interest rate is not determined by the lender, but rather by the market forces of demand and supply.
Why is it riskier to borrow than to buy?
Suppose a trader buys the stocks of a hypothetical company called Platinum Tech. Immediately after the trader takes his position, and gets a stake in the company’s future, the stock prices fall due to management changes. Now, this is contrary to the trader’s expectations, and his holdings have been devalued for sure. But the trader can wait out the recent management changes. If the fundamentals of Platinum Tech are solid, then the company will weather the storm that its stock prices will likely go up again. The trader can clear his positions when the market changes course and the prices move favorably in his preferred direction.
As a borrower of stocks, though, a trader does not have the luxury to wait out any unexpected and unfavorable turn of events. Let’s take the example of another trader who borrows the stock of another hypothetical company, Gold Tech. The trader expects the stock price of Gold Tech to trend downward, and hopes to make a profit by short-selling the stock.
Contrary to his expectations, Gold Tech goes on a bull run. Perhaps they introduce a new product that is a hit with a lot of people, and investors rush to put their money in this company. Now, this security lending and borrowing scheme is not working in the trader’s favor. As a borrower of stocks, our trader does not have the luxury to wait out this development. There is a tenure within which he must return the borrowed stock. Meanwhile, inside the tenure, the trader must keep paying the applicable interest rate. Therefore, he will make a loss on two fronts. The upfront loss will be that of the interest paid to borrow the stock. If the trader sold the stock in the open market, hoping to buy it back at a cheaper rate, he will now need to buy it back at a higher rate since he needs to return the borrowed stock. That difference will be his secondary loss.
For the increased associated risks, stock lending and borrowing is a practice normally seen among more experienced, and more risk-tolerant, traders.