Stock borrowing is the act of receiving a number of shares as a loan from another financial entity. This loan is generally backed up by collateral for the total or partial value of the loaned shares and is accompanied by a rate of interest on the borrowed value.
Stock Borrowing in Trading
While there are a few reasons why an investor would want to borrow shares, stock borrowing is usually done in the case of short selling. The investor borrows and sells the shares at a given price in the hopes of being able to buy the shares back at a lower price to pay back the loan at a later date.
The difference in the original sale price and the subsequent purchase price, minus the cost of the stock borrowing, is the profit from the short sale.
Margin and Financing
Stock borrowing agreements usually contain a margin requirement for collateral on the value of the loaned shares and financing terms in the form of a rate of interest on the borrowed amount.
For example, an agreement to borrow 100 shares of company A when the shares are worth $1 each with a 20% margin requirement would mean that the borrower would need to deposit $20 worth of value with the lender.
This margin requirement is important when the price of the loaned shares increases, as this would increase the amount of collateral required to meet the margin requirement.
When a number of borrowers are forced to liquidate some or all of their short position to meet an increased margin requirement, this can cause a further increase in the price of the underlying stock, which can in turn further increase the margin requirement and subsequent forced liquidations.
This process is known as a ‘short squeeze‘, and is an essential element in short selling.
Margin financing terms will vary widely depending on the borrower, lender, underlying stock and size of the loan.
The ability of financial entities to arrange complex contracts involving the lending of shares and their use as collateral is an important element in advanced financial markets that allows for the development of highly complex and sophisticated trading positions.
However, this complexity requires investors to understand the full implications of the positions that they take, including the possibility of events like a short squeeze.