So here is my latest idea for trying to juice extra returns out of my trading account. While I was short the Egyptian market ETF, I was getting charged an arm and a leg to borrow the shares from the broker in order to do this. About a 60% annualized interest rate! This got me thinking if there is some money that could be made here. First of all, just a quick background what selling short means. Basically if you believe the price of a stock will decline, you can borrow shares from the broker and sell them in the market. You have a negative balance of shares in your account. Once the price (hopefully) moves lower, you buy the shares back in the market and return them to the broker, while pocketing the profit (or loss).
So what are the basic mechanics of a short sale?
- Borrow shares from the broker. If the shares are in high demand or if the broker just doesn’t have many shares to borrow, the broker can charge an extremely high interest rate.
- Sell the stock into the market, and collect cash from the sale. This cash acts as collateral to the stock that was borrowed.
- Buy the shares back in the market, and return them to the broker.
There is an interesting wrinkle here in the fact that Interactive Brokers will allow customers to loan shares that they own to other customers who want to short a stock, and charge interest on the transaction (just like the broker does). Interactive Brokers calls this the AQS marketplace. Customers looking to borrow shares can either borrow shares from the broker or look at the AQS marketplace to see who is charging the lowest interest rate.
From the screen shot above HDY can be lent out at 61.60% annual interest and BDCO can be lent out at 4.76% annual interest.
The idea here would be to purchase shares where the interest rates quoted on AQS are high, (such as the 60% example for EGPT shares I mentioned above), and then loan those shares out via AQS. The obvious risk here is that the stock that was purchased drops in value, such as EGPT has over the past week, in which case, the interest collected would not cover the loss. To help manage this risk, a hedge could be constructed offsetting the position with:
- A short position in another security that is cheaper to borrow, but is highly correlated to the stock being loaned out.
- Creating a delta neutral position using options, most likely deep in-the-money put options that have little time premium.
- A short position in single stock futures.
Now if a hedge can be constructed using any of these scenarios, than most likely the interest rate one could charge to loan a stock may not be as high as the 60% EGPT example since a synthetic short position could be constructed using the same techniques. There can always be mispricings however in a given market, and this is what I am hoping to find.
Another factor to consider is the transaction costs as well. If the costs are significant to hedge a position and the borrower returns the shares after only a few days, the transaction costs to unwind the hedge may eat into any profit that had been made through collecting interest.
I’ll be exploring this a little further by starting to manually look for opportunities in this market, and if it appears that this is something that may be viable, then I will write software to automate the search for potential mispricings.