The cost of short selling Term Paper Example | Topics and Well Written Essays - 3000 words - 1

The cost of short selling - Term Paper Example A short sale, in general, requires loaning a security and comprises two parties- the borrower and the lender. Stock lending can take place directly or through intermediate agents. The fee for lending is a factor of market demand and supply; low supply or high demand raises the fees. It is said that short selling also influences the market price of a stock; for this reason the regulatory bodies restrict short selling in times of depressed market conditions. Another argument that goes against short sale is the high costs associated with it in the form of margin interest, commission and bid/ask spread. Other than these short selling is also exposed to dangers like unlimited losses, uptick rule etc. Other proxies are available in the market such as options that can replicate short selling and are also said to be less costly. Short selling costs Collateral and margin requirements- Short selling a stock is the opposite of going long on a stock in a â€Å"margin account†. An investor borrows the shares from the brokerage firm. As the seller does not own the stock he has to furnish collateral such as T-bills or cash (AIMA Canada, 2007). These serve the margin requirements of short selling. The amount which the investor has to deposit in the account at the point of initiation of sale is known as ‘initial margin’. ... a total of $13500 (Investopedia, 2010). Bid and ask spread- In a stock quote there are two prices- bid and ask. In the case of a short sale an ordinary investor sells the security at the bid rate. For this kind of investor the broker transmits the order to the stock exchange. At this point the market maker or specialist sells the stock and makes a profit equivalent to difference between the bid and ask rate referred to as ‘spread’. Suppose the bid and ask of Microsoft is $25.95 and $26.05 respectively. Then on a short sale the market maker will enjoy a spread of 10 cents. The profits earned on each trade may be small but the market maker can make huge profits in the case of bulk trading volumes. The amount shelled out as ‘spread’ is borne by the ordinary investor. The ordinary investors fail to realize this and place trade using market orders. In this kind of trade an investor may not get a good return on trade. Margin interest- Most of the firms charge an i nterest on the amount of securities shorted in an account. Going by the low rate of interest this may appear to be small but this can in due course add up with time. Suppose if an investor shorts $8000 worth of security ABC and the interest charged on the account is 6 percent then the investor will have to pay $480 as fees for that year. In the case of highly liquid stocks an investor can also ask for waiver of margin interest. Commissions- The amount paid as commission varies as per discount brokerage firms and full service. An investor has to pay a higher rate of commission in the case of full service brokerage on account of the personal counselling and guidance. But this may not prove to be always