Hard-To-Borrow Stocks Trading Strategy

Hard-To-Borrow Stocks Trading Strategy (Negative Returns)

In the US, hard-to-borrow stocks underperform over 3-, 6-, and 12-month periods. Moreover, hard-to-borrow stocks consistently underperform those that are not hard to borrow.

Is that negative edge big enough to make a hard to borrow stocks trading strategy?

Verdad Research, a money manager, publishes a weekly research every Monday. In a recent paper, called Costly Shorts, they went through the returns of stocks that are hard to borrow. 

Let’s look at some of the findings from Verdad:

Hard-To-Borrow Stocks Trading Strategy

Hard-to-Borrow Stocks Interesting, But Impractical

Verdad’s model classified stocks based on their borrowability. If you are unsure what we mean by hard to borrow and why it’s significant, please read further below for an explanation. 

Classifying stocks into deciles of hard to borrow stocks, Verdad generated comprehensive daily short-borrow classifications for a substantial dataset of nearly 30,000 stocks spanning from 2005 to 2023.

Based on this dataset, Verdad made the following conclusion:

“Our analysis shows that, in the US, hard-to-borrow stocks typically show negative returns over 3-, 6-, and 12-month horizons, whereas general collateral stocks tend to yield positive returns over the same periods……. In Japan and Europe, hard-to-borrow stocks do not appear to systematically underperform as they do in US markets.”

Based on deciles Verdad made the following table:

Hard to borrow stocks trading strategy
Hard to borrow stocks trading strategy

We believe median results might shed some more light on the performance and these two tables tell us that small stocks perform very poor:

Hard to borrow stocks performance
Hard to borrow stocks performance

We are not surprised that small caps perform badly: we know from history that volatile small-cap stocks have been the worst performing stocks for over 60 years. 

But is the negative edge big enough to turn it into a profitable and robust short selling trading strategy?

Probably not, because you most likely would not be able to get a short locate. 

What does that mean? Keep reading to learn more about short selling:

Why do we need to borrow stocks when selling short?

A short sale is a sale of shares, and you can’t sell thin air. You need to have shares to sell, thus you need to borrow from someone else and sell those shares in the market. You need to pay fees to borrow shares, sometimes quite high fees. 

When you cover, ie. buying back the shares, you deliver the shares back to the lender. 

The lender of the shares is unknown to you. Brokers ask their clients if they are willing to lend their inventory to short sellers, and both the lender and the broker get paid for that. Thus, it’s the broker that facilitates the borrowing of the shares.

If you sell shares without any locate, you are a naked short seller, something which is strictly forbidden.  

Why is a stock hard to borrow?

A stock is considered hard to borrow if it is difficult to obtain for short-selling purposes. Hard to borrow means exactly what it says: it’s hard to find shares to sell short. 

A stock can become hard to borrow due to several factors, such as:

Limited Supply: If there is a relatively small number of shares available for borrowing, it can be challenging for short sellers to find and acquire them.

This can be particularly true for stocks that are thinly traded or have a low float, which refers to the proportion of shares that are available to trade. Small caps are, as it says, small caps, and thus many are hard to borrow. 

High Demand: When a stock is in high demand among short sellers, the supply of available shares becomes even more restricted, making it harder to borrow and increasing the cost of borrowing. This often happens during periods of market volatility or when a stock is perceived to be overvalued.

Shares are still the least available when they are most attractive to short sellers. However, a high short interest ratio is followed by poor performance (if you are long). 

Regulatory Restrictions: In some cases, regulatory restrictions may limit the availability of shares for borrowing.

For instance, Regulation SHO, enacted by the Securities and Exchange Commission (SEC), aims to prevent excessive short selling and protect investors from market manipulation. This regulation can sometimes make it more difficult to borrow shares of certain stocks.

Stock Loan Fees: When a stock is hard to borrow, brokers may charge higher fees to investors seeking to short sell it. These fees are compensation for the broker’s efforts in locating and borrowing the shares, as well as for the risk associated with providing them.

The range can be from 1% to as high as 50%!

Locate Requirements: For hard-to-borrow stocks, brokers may require investors to place a “locate request” before placing a short sale order. This means that the investor must find a source for the borrowed shares before initiating the short sale. This can add another layer of complexity and potential delays to the short-selling process.

In summary, a stock being hard to borrow means that it is relatively difficult to obtain for short-selling purposes due to limited supply, high demand, regulatory restrictions, increased stock loan fees, and locate requirements. This can make short selling a more challenging and expensive endeavor, especially for thinly traded or volatile stocks.

How much does it cost to borrow shares for short selling?

The cost of borrowing shares for short selling can vary significantly depending on the stock’s characteristics.

Generally, large, stable, and liquid stocks have lower borrowing costs, while smaller, volatile, and illiquid stocks can be much more expensive. This is because there is a higher risk associated with borrowing shares of a stock that is more likely to experience sudden price movements.

Factors Affecting Short-Borrow Fees

Stock Size: Larger companies tend to have more shares available for borrowing, making them more liquid and less prone to price manipulation. This means that short sellers are less likely to face difficulties in locating and borrowing shares of large companies, leading to lower borrowing costs.

Stock Stability: Stable stocks with predictable price movements are generally considered less risky for short sellers. This is because there is a lower likelihood of significant price declines that could force short sellers to cover their positions at a loss. As a result, borrowing costs for stable stocks tend to be lower.

Stock Liquidity: Liquid stocks are actively traded and have a high volume of shares exchanging hands regularly. This makes them more readily available for borrowing, reducing the cost associated with locating and obtaining the shares.

Stock Volatility: Volatile stocks exhibit frequent and unpredictable price movements. This makes them riskier for short sellers, as they may need to cover their positions at a loss if the stock price unexpectedly rises. As a result, borrowing costs for volatile stocks tend to be higher.

Change in Short-Borrow Fees

Short-borrow fees for individual companies can fluctuate significantly over time, reflecting changes in market conditions and the stock’s own performance.

For instance, GameStop’s short-borrow fee rose dramatically in early 2021, driven by an intense short squeeze initiated by retail investors.

According to data from IHS Markit, GameStop’s average short-borrow fee in January 2019 was around 1% (before the short squeeze).

However, by January 2021, coinciding with the surge in short interest and the subsequent short squeeze, the short-borrow fee skyrocketed to a staggering 34%. This exceptional increase highlights the significant impact that market events and speculative trading can have on short-borrow fees.

Short selling is risky

Because potential losses are unlimited, and shorting is thus risky. We recommend reading our take on the pros and cons of short selling to understand more.

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