Many financial instruments can benefit individual or institutional investors in the stock market. As the economic environment changes, certain tendencies become more popular. During strong economic growth or bull market, investors shift a higher percentage of their portfolios toward growth stocks. Investors prefer value stocks and safer investments during an economic slowdown or bear market. Since meme stocks became a hit mainly due to short interest, increasing shares are being lent and borrowed on the stock market. How does this work, and how do you benefit from stock borrowing? Let’s find out below.
What Is Stock Borrowing?
Before we get into the specifics, what exactly is stock borrowing? Simply enough, it is receiving shares as a loan from another party. Since borrowing a stock is followed by shorting it, only stocks with options contracts can be borrowed. Generally, the agreement won’t last longer than 12 months. Next, it comes with fees and an interest rate. After all, nothing in this world comes for free.
Furthermore, collateral must be provided to secure the loan. An important fact to note regarding the collateral is that if the price of the stock increases, the collateral amount will also have to increase.
Many brokers require the value of the collateral to be at least 100% of the value of the shares borrowed. This important information will be crucial when it is time to understand a short squeeze. The collateral, interest rate, and fee depend on the broker and the borrowed stock.
Stock Borrowing Interest Rate Example
In this section, we will examine the interest rate of a famous meme stock: AMC Entertainment (NYSE: AMC). Many brokers earned record revenue from the proceeds of stock borrowing. Securities lending in Q1 2023 generated $2.76B, a 27% YoY increase.
The top breadmakers for brokers were AMC Holdings with $181M, Beyond Meat (NASDAQ: BYND) with $68M, Lucid Group (NASDAQ: LCID), Roche Holdings AG (OTCMKTS: RHHBY) and Upstart Holdings Inc (NASDAQ: UPST).
For a normal stock, the interest rate can fluctuate between 0.1 to 3% annually. What about meme stocks? In April 2023, the average annual interest rate to borrow AMC stock was over 100%. Some brokers even charged up to 1000%.
In April 2022, that rate was only 12.75%, which was still above average. Those are astronomical numbers to borrow stock and show how much interest these stocks have gathered over the last quarters.
Many investors were sure AMC’s stock price would drop and decided to purchase it. If their timing was correct, they made some big money. Unfortunately, they may have lost a substantial sum if their timing was wrong.
These stocks fluctuate a lot, especially when there is good or bad news. A short squeeze is likely to occur when a stock is heavily shorted and good news surfaces. We will discuss this later in the article.
How Does It Work?
In most cases, investors seeking to borrow a stock aim to short it. After obtaining the loaned shares, investors immediately sell them, hoping to buy them later at a lower price.
In the meantime, since they own the shares, they receive the dividends paid, if any. The new owner of the shares also has the power to participate in any shareholder meetings and decisions.
How to Earn Income From Stock Borrowing?
Those not interested in borrowing shares can make money by lending them through your broker, such as Robinhood or TD Ameritrade. Here’s an easy example to understand.
If you lend 1000 shares with a current stock price of $100 and the interest rate is 5%, the daily interest looks like 1000 x 100 x 5% / 360 days = 13.88$. This is what the broker will earn. You will earn a portion of that amount. A real-life scenario will have daily changes in price and interest rate. The daily amount received from your broker will vary in function of those variables.
Can you sell your stocks while they are loaned? Yes, you can. It will terminate the loan agreement. Read your agreement with your broker to clearly understand the specifics of this transaction.
What Is a Short Squeeze?
Many investors became familiar with the term short squeeze during the first meme war in 2021 between Reddit and evil short sellers. The first thing we need for a short squeeze is a heavily shorted stock.
The fan favorites were Game Stop, AMC, Bed, Bath & Beyond, Beyond Meat, and Carvana. Around 40% of their float was shorted. These companies lost billions of market capitalization in the last three years. Bed Bath and Beyond went bankrupt despite all the action surrounding its stock.
Next, we need some positive news for the heavily shorted stocks to happen and to attract an increased buying volume, driving the stock price higher. Remember about the collateral needed to borrow a stock?
Well, now the amount needed as collateral increases. If the price keeps increasing, some short sellers are forced to exit their position or increase their collateral. As a consequence, this will increase the price of the stock even more. It quickly becomes a vicious wheel for those shorting the stock. Their margin requirement keeps increasing, and they keep losing more and more money until the stock finally returns to earth, if it does.
For more information about short selling, options, meme stocks, and more, follow the links provided for each topic. We have amazing resources to help you with your everyday trading.
Is Borrowing Safe?
Lending your stocks is a safe way to earn extra funds, but the following must be considered.
Tax implications: If your stock pays dividends, you won’t receive them while your shares are lent. You will instead receive interest payments that will be added to your income and taxed at a different rate. If your income is high, you will likely pay more taxes than with dividends.
Shares insurance: When you purchase a stock with a broker, your shares are SPIC insured. When they are lent, your shares love that coverage. If your broker cannot make the payments, you may lose all or a portion of your shares.
Borrower default: Borrowers must put collateral to borrow shares, usually over 100% of the amount borrowed. If they go bankrupt, you will receive the collateral, not the stocks. You will have to repurchase them with the funds received.
Now You Know How to Borrow
To conclude, stock borrowing and lending have many uses for investors. You can earn daily interest revenue for those wishing to lend their shares to their broker. As for those monitoring the stock market and shorted stocks, you can make the appropriate moves to earn (or lose if you’re not careful) much more.
