Investment XYZ

Tuesday, December 19, 2006

Economy of Stock Shorting

In my earlier article, I discussed how stock shorting works in the equity world by facilitating liquidity. In this article, I will analyze in detail the interests and money flow of stock shorting.

Stocks vs Contracts

Comparing with derivatives or futures contracts, stock shorting seems more mysterious. For a contract, shorting is always symmetric to buying (or longing) because a contract always has two sides when it is established: the buy side and the sell side. Thus there is no special rules against shorting versus longing. Then why stocks are different? We have Regulation SHO from SEC on "failure to deliver" which is mostly applicable to short stocks. The brokers have "hard-to-borrow" list to warn investors of shorting certain stocks, and we have non-shortable list that simply disallows investors to short certain stocks altogether.

The reason is a stock is considered as an equity, not a contract. Even though each trade is made of buy side and sell side, there is an asset changing hand in the transaction. The natural assumption is the sell side has to have the equity before the transaction, otherwise, it is not a sell, but a "short". Obviously for contracts, there is no such distinction at all. When a contract is opened, selling is exactly like shorting; while an existing opened contract change hand, selling is different from shorting, but it is simply a book keeping notation in regarding to the resulting position of the traders. At the transaction of the contract, there is absolutely no distinction between selling or shorting.

In my view, the argument that stocks are different from contracts is quite arcane, considering how the modern stock market works: when public traded stocks are transacted, there is no longer paper certificates changing hands (unless under the special request from the stock holders). A stock equity is no longer a physical asset, instead, it becomes a "right" to an asset -- exactly the same as a contract. In another word, the modern stock market behaves exactly like contract market for futures and derivatives: they are all trading the rights, or a generalized form of contracts, rather than actual paper certificates. Thus in theory, stock trading should be exactly the same as contract trading: there shouldn't have a distinction between "short" and "sell".

We are not going to further discuss in this article the rationality of whether equity is different than contracts, instead we take whatever in the current reality -- the regulatory restriction around stock shorting, and we will analyze how exactly it works in the money flow, so that we can understand all parties involved in the process, who takes risk, who provide the facilitaty and liquidity.

Moneyflow in a Stock Sale

Supposed "A" sells 1000 shares of a stock to "B" at the price of $20, through broker X (commission: $10). Here is the money flow of this transaction:

- "A" will take in cash of $20000 - $10 = $19990. This cash will accrue interests, supposedly at the interest rate of 4% (typically below the common market borrowing rate, say 5%).

- "B" has to put up cash $20000+$10 = $20010 for the purchase. The cash will be borrowed from the broker, thus being charge at 5%. B is now a stock holder.

- "X" will take in $20 for commission, plus 5% on $20010 less 4% on $19990. He only needs to finance the difference of $20 between the loan and deposit.

In this picture, the sole risk taker is B. If the stock he is holding appreciates in equity market value more than 5% of the financing rate, he has a good trade. Otherwise, he is losing money -- even if the equity price is unchanged, or appreciates slowly (say, 2%), he would still loss money. How about "B" does not borrow money from the broker to finance the trade? The above conclusion is still the same -- because the cash he uses for the stock purchase is now deprived of the interest earning power as a deposit, thus the equity appreciation still have to be at least 5% for this trade to break even.

Broker "X" does not take market risk (but takes credit risk), and he earns his risk-free money as fees and interest spread because he provides liquidity and financing facilities to make this transaction possible. It is worth noting that in the long run, the interest spreads the brokers earn (for provide financing) may well surpass the commissions earned (for provide liquidity). For example, in the above example, the interest spread the broker earns is $200/year.

Moneyflow in A Short Sale

How would short selling be different from the above process? Supposed "A" wants to sell short the stock. He shorts 1000 shares at $20 to "B" (who will buy 1000 shares). Here is what will happen before the settlement (Within 3 trading days, or T+3 rule): Broker X will have to locate the shares to borrow for A to sell short (while for B, he has no idea whether he buys the shares from someone who shorts, or some who sells an existing holding). Supposed "X" borrows it from "C", another stock holder depositing his shares with Broker Y. To facilitate the borrowing, Broker X has to put up the collateral of the cash value of the current stock value (actually the collateral amount should be slightly higher than the actual cash amount, but for the sake of simplicity, I assume they are the same). The collateral cash will be transferred to Broker Y, who would deposit it for interests. However, the typical borrowing contracts require Y to rebate most part of interests back to X (which make sense -- after all, the cashcomes from the proceeds of "A"'s short selling), unless the stock is very scarce or "hard-to-borrow", in which Y can demand to rebate a smaller portion, or none, back to X. In some extreme (but no uncommon) cases, not only Y does not rebate back to X, he may even request X to pay him a premium for the borrowing.

Let's consider the typical case: Y rebates most of the interests of collateral back to X. What happen to these rebate dollars? Does Broker X gives it back to customer "A", who generates a cash deposit from the proceeds of the short sale (such cash deposit makes up the collateral for the stock borrowing)? That depends on the brokers. For individual investors, because of the cost in the operation of borrowing, Broker X may not pay much to "A" at all. For broker/dealers or big funds who would negotiate with the broker, "X" will pay most part of the rebate back to "A". Thus the interest rate for the short stock proceeds is called "short rebate rate".

The moneyflow looks like this:

- "A" will take in cash of $20000-$10 = $19990. The cash will be deposited but not earning the typical deposit interests, instead it will earning short rebate rate, say it is 3.5%. Now "A" is holding a short position.

- "B" will use $20010 cash to buy the stock from "A" and will be charged for 5% interests for the borrowed cash. "B" is the stock holder.

- "X" will take in $20 commission, charge "B" 5% for $20010, pay 3.5% rebate rate to "A" for $19990. "X" will forward $20000 (the cash from "A"'s short sell) to Y as collateral for stock borroowing, while receiving 4.0% from Y as the rebate.

- "Y" will take $20000 cash from X as collateral, deposit in the bank to earn 5% interests income, but pay 4% back to X as rebate. Y will take the shares from one or multiple investors' stock deposit and lend them to X. Supposed this stock holder is "C". Does he knows about his shares are being lent out? Unlikely, unless he requests a stock certificate.

- "C" is still a stock holder, even though his 1000 shares are lent out to "A" (facilitated through brokers X and Y) to sell to "B".

Now we have two stock holders "B" and "C", each has 1000 shares, and A has a short position of 1000 shares.

When the company issues dividends, B and C both expect to receive dividends, one will get the cash from the company, another will get the cash from "A", the short position holder. However, for A, even though he has to pay out dividends, there is no loss to him no matter what amount the dividend is, because on the ExDiv date, the stock price will drop exactly the dividend amount, thus the dividend distribution will not incur any gain or loss for A or B or C.

A, B and C are all taking risks. Their gain or loss in equity value are subjected to equity price movements. For B and C (stock holders), the equity price should appreciate faster than interest rate (5%) for them to be profitable. For "A", equity price should not appreciate faster than 3.5% to avoid loss.

Does Broker Y pays "C" any portion of the 1% interests he retains (5% deposit less 4% rebate to X) to "C"? Not necessary, unless C is a major investor and have agreement with the broker regarding stock lending -- as an individual investor, I have never seen a penny from my brokers for stock lending. Supposedly "C" is a big fund manager and he gets Broker "Y" to pay him half of whatever interest income after rebate. Now a simple short stock transaction creates 3 additional risk free net gainers: Broker X (net gain 0.5%), Broker Y (net gain 0.5%) and C (net gain 0.5%). The origin of such gains come from the cash proceeds of "A"'s short sell, which in theory should have a money growth rate of 5%, nevertheless, "A" receives only 3.5%, while the rest is distributed to other parties along the process.

It is worth noting that if both A and C are individual investors, "A" may receive much lower rebate rate for the cash, say 2%, while C never gets anything from his broker (and never know whether his shares are lent out or not). The interest spread of 3% (5% - 2%) is earned by the intermediaries, Broker X and Y.

Negative Short Rates

The above example illustrates the complexity of stock shorting. Brokers have to locate and borrow shares, arrange collaterals for the borrowing, negotiate rebate rates, and have to do the necessary book keeping to separate out the cash proceeds from the rest of "normal" cash. Such complexity can have some negative effect on the market liquidity. One common side effect is the negative rebate rates.

It is not uncommon to see a stock having negative rebate rates for a certain period of time. For example, GM (-20% in the mid 2006 when the stock tanked with all the talks about potential bankruptcy); ALD (a perpetual negative rebate rate name due to constant battle between major shareholders and short sellers); NYX (-12% in December 2006).

Negative rebate rates arise from the situation when the stocks become very hard to borrow. In that case, the stock holders (actually it is most likely the brokers who have the stocks in their custody) can demand that not only they will not give rebate of the collateral, they demand the borrower to pay more to borrow shares. If that happens, "A" will have to pay interests (instead of collecting interests), and the net proceeds from "A"'s interest payments, in addition to deposit interest income from his cash as collateral, will be distributed among the 3 parties (Broker X, Y and possibly stock holder "C").

If the stock holders can demand a special rebate or even negative rebate, why not everyone does so? In the end, supply/demand and competition in the market will come into working and pull this back in balance. If one shareholder makes special demands, while others simply follow the norm, the special demands will end up useless because no one will borrow from that shareholder. Obviously if the shares of a particular stock is concentrate in a few big holders, they can exert power to see special demands get implemented and the ability to short stock become skewed.

Contract Market Can, Why Can't Stock Market?

Are all these complexities necessary? In the contract world, where short and long are absolutely symmetric, there is none of these complexities -- no special requirement for locating and arranging shares to borrow before settlements, thus there is no place for the collateral deposit and rebate, and certainly no place any stock holders to make special demands for rebates, which in the cases of high concentration of shares in a few share holder's hand, can amount to extortion and impediment to market liquidity.

How can contract market rid of these nuisances and still functions well? The magic lies in a simple concept called "fungibility". It says that any contracts of the same type publicly traded on exchanges are equivalent after settlements, no matter who are the counterparties of the trades. For example, if someone wants to sell a contract, if he can open a new contract, or he can sell existing one. The two cases do not make any difference because at the end of the day at settlement, any long or short positions of the same type under a holder will netted out. There is no need for the "borrowing" process.

It is really simple, isn't it? And it should be this way. In the stock world, the special borrowing process actually make stock non-fungibile: shares owned by certain shareholder can make demand for special rebate rate, thus causing the ridiculous situation that same stock can have different kinds of rebate rate on different brokers.

The power of fungibility allows contract market to achieve two things that the much older stock market cannot achieve: 1) One day settlement (stock settlements take 3 days, even in the modern day that all trading are powered by computers); 2) No special rules for shorting, thus no complexity in the special rebate rates.

In my view, all these complexities and inefficiencies derive from the historical limitation that stocks come as a tangible asset as paper certificates. In the modern market, we should abandon the arcane view that stock is a special physical equity, and adopt the view that stocks represent rights just like contracts, we can then throw all these regulations as well as the paranoids regarding shorting stocks out of window. The contract markets show that a symmetric long/short market can function well and healthy.

(The author can be contacted at

Wednesday, December 06, 2006

Put Option Musical Chair

Today I come to a posting (originally on Yahoo message board) regarding an interesting OVTI put trade:

"Insider Info (1 Rating) 6-Dec-06 12:22 pm Ok kids.... so now after some of you
lost a bunch of money on this stock you will not be surprised when i tell you
how funds take advantage of PMIs (passive minority investors). Want to know what
will be with OVTI in the next 4 weeks ? Shorts are gonna cry this time. Longs
will do good.

What supports this statement?A big fund (can't tell u the
name yet) bought 35000 17.50 for March 2007 puts at the end of last week. They
also have established a huge long stock position on the recent weakness of OVTI
(post announcement). Today, the same fund wrote 35000 30.00 puts for January
2007. Therefore they established so called time spread.I believe that the
smartest ones out there will know what to do with this info :)...."

What's going on with these trades? Is it really anything to do with "bullish" or "bearish" of OVTI, or anything to do with the sophisticate sounding "time-spread"? I doubt, because for such deep in-the-money put (OVTI is $14.17, so this put is $15 in-the-money), one would rather just trading stock rather than trading put. I pull up the current and historical data of OVTI Jan07 30 Put, indeed on 12/5/06, there are 35604 contracts traded. Furthermore, today it has 18004 contracts traded. This is very peculiar -- the open interest of this option is only 8800!

It gets even more interesting: look at the history of this put in past few months, such large trades (10000 to 30000 contracts, representing 1 million to 3 million shares) occurred repeatedly: 12/4/06: 20K; 12/1: 10K; 11/30: 20K; 11/28: 19K; 11/22: 10K;11/21: 30K, 11/20: 20K; 11/14: 10K; 10/18: 12K; 10/17: 38K, etc. While all these huge trades were going on, the open interest stay roughly the same at around 9000! Actually after a huge size trade, the OI stayed exactly the same the next day, indicating the party who bought the put immediately exercised on the same day.

So what's the point of all these trades? One speculates that since the long side exercise right away, it must be done to capture some discrepancy in parity (this put should trade exactly at parity theoretically, since time and volatility is zero at such deep strike). However, if one side can pocket such free money, the other side would lose the same amount in the mean time. Since such a large trade typically is done with two parties who understanding each other's intention very well, it is impossible to expect one party to ask for free money from the counterparty in a straightforward way and do a trade.

The economy of such a trade is quite subtle. It lies in statistics and work in the similar way as call exercise to capture dividends. However in this case it is trying to capture interests, with a pre-determined probability of getting the "free" money, which is different from typical arbitrage, where the free money is captured with certainty until the arbitrage opportunity disappears. Which side of the trade can get such free profit? It is the short side (the side write the puts). Then does the long side become the opposite side to the free profit (thus would incurs immediate loss)? No. the long side of the trade is not the automatic loser otherwise there would not have any trade.

Where does the free profit come from? The magic lies in the open interest of this put. The put, since it is deep in-the-money, should be exercised. Otherwise the put holder is losing the interests he should get. If he exercises, he would end up with short stock position, which should entitle him to short interest rebate. On the other hand, if he continues to hold the put, not only he is not collecting interest payments, he is paying interests to the broker for the cash he used to purchase the put. The fact there is a large open interest in this put indicating there are some put holders who do not understand such money relationship and simply let the free money flow away every day until expiration.

Who would be on the receiving end of free money that the long side of the open interest is losing? Obviously it is the short side. Typically it is the market makers on that end thus the short put positions are hedged 100% by shorting stock. Such hedged position is indifferent to the up and down of stock movements. The "free" money comes in the form of short rebate the short side would receive. If the long side is not hedged, he is equivalent to holding a naked short stock position, thus he is subjected to the daily movements of the stock. It is likely that the interest he would lose appears to be negligible comparing to the stock fluctuations.

So why there are those new trades -- with the long side exercise immediately? Isn't it a total waste of money? It turns out that a rule by Option Clearing Corporation (OCC) in option exercise allows the transfer of free profit from one party to another through the assignment process.

Here is how it works: since option is so-called "fungible", after an option trade is made, two parties of the trade are no longer associated with each other. The trade goes into the pool of existing open positions called "open interest", which has equal number of long and short. When an exercise order comes in, who (among all the holders of short positions) should be get assigned? OCC uses a lottery system to pick the party to be assigned from the pool. Thus if the open interest of an option is 1000 and there is an exercise order for 100 contracts, each short position contract has 1/10 chance being assigned. All in all, such lottery is very fair and effective.

Now back to the trade I am discussing above. The open interest is about 10K, if a 20K contract trade is made, by the end of the day, the long side of the trade will immediately send in the exercise order for the 20K contracts. Now OCC has to randomly pick among 30K (=10K + 20K) contracts of open interest to assign the 20K contracts. Thus the party who was originally collecting free interest money, now has 1/3 chance to be kick out, while the short side of the new trade will have 1/3 of chance to get in and sit in the musical chair to receive free profit.

Here is the whole picture: we have some speculator who is holding 10K OVTI Jan07 30 put. Since OVTI is tanking, his put position is extremely profitable from the stock movement that he forgot (or simply does not understand) to exercise the put and make more money through interests. Now his counter-parties (the short put side but hedged, thus not exposed to stock movement) are all happily collecting interests for free from these 10K contracts that should have been exercised. But wait! Since it is free money, other people who can understand such mathematical relationship and has resource to do it, want a piece of the cake too. So there are all these huge trades happening, trying to get into the action to grab a piece of the free money. The lottery system in option assignment provides a fair opportunity (with a certain probability) for anyone who want to sit in the musical chair.

How big is the potential profit? For each contract of Jan07 30 put, the short side would hedge with 100 shares of short stock, resulting in total $3000 cash (no matter what is the stock price, as long as the stock is well below $30). If the short stock interest rate is 4.5%. For 10K contracts, how much is the interest?

$112,500.00 per month

That is some serious free money. Since OVTI dropped below $20 since July 2006 (thus this put should be exercised at that time and the open interest should be reduced to 0), the total free money (to option expiration in January 2007) for these 10K contracts of sitting position is more than half a million. Obviously that is good reason to get into action for a piece of that. Looking back at the history, the first 20K of such seemingly pointless trade occurred on 9/5/06, when OVTI dropped to 15.45.

How can these trades be made? Considering OVTI is quite a volatile stock, and bid/ask spread on these deep ITM puts are wide, after trading such huge size of options, then put on the hedge, then paying the commission, the cost already wipes out any potential free profit. It seems it doesn't make sense at all.

In reality, such trade are arranged by a broker, with both parties understand exactly why they want to made the trade. The trade will occur at parity with hedging stock trade also complete by both sides. Here is how the economy in this trade: the long side, who is typically the broker (thus the broker not just facilitate the two sides, but likely become one side), would set the price for both the option and stock together exactly like the theoretical value. Thus both sides has no directional risk, and the hedging stock and the option simply pass from one party to another, thus no market risk. After the trade, the long side would exercise immediately. For the entire trade he would just make money on the commissions, nothing else. The short side would lose on the commissions, but trying to get a piece of the half million free money.

Then why doesn't such trade occur in all the deep in-the-money put? The precondition is the puts need to have large open interests standing. Otherwise there is no point of making such a trade.

For regular investors, it is unlikely they can make such trade, due to 1) capital usage; 2) high commission. However it is important for investors to understand the economy and reasons behind such trades, so that they won't make laughable speculation that some fund is bullish or bearish based on these trades. These trades have nothing to do with stock direction at all, neither with 'time spread". It is a purely interest rate and statistical trade (due to the lottery assignment system) that arbitrage on one party who does not understand the mathematics of options fully.

(The author can be contacted at

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