I tried to short iShares Lehman 20+ Year Treasury Bond Fund (TLT) today and was rejected by three different brokers due to unavailability. Do you have any suggestions on where to go?After numerous emails echoed that complaint, I decided to perform an impromptu and unscientific study into the feasibility of shorting these contracts. But before I reveal my findings, let me briefly review what a short sale is and the process of doing it.
Selling What You Don't OwnIn a short sale, you're essentially borrowing shares to sell to someone else, in the hopes of buying them back later at a lower price and pocketing a profit. The process of locating available shares is the responsibility of a brokerage firm's stock loan department. Most large firms do this in-house, while smaller firms outsource the job to prime brokers. One of the great profit centers for investment-banking firms is the ability to offer prime brokerage services to institutional and hedge fund clients. A major determinant in the ability to borrow or short shares is the total number of shares available to trade, also called a security's float. Technically, short-sellers should earn interest on the credit that their accounts receive from short sales, but brokers often charge a fee for the cost involved in locating and lending hard-to-borrow shares.
Focus on OptionsOf course, I'm here to tell you how options can help you avoid all this aggravation. Buying puts on these bond ETFs will create a bearish bet that rates will rise. But to truly recreate a short share position, consider constructing a synthetic short using options. You'd do this by simultaneously buying a put and selling a call with the same expiration date. For example, with TLT trading at $95, you could buy the July 95 put for $2.50 and sell the July 95 call for $1.70 for a net debit of 80 cents. Essentially, that makes you short TLT at $94.20. The discounted sale price is the cost of the premium paid for the option. If you plan to use a synthetic position, be aware of its limited lifespan and the increased margin requirement of maintaining two option positions. Also, consider the low volume and lack of liquidity in these new ETFs. You might want to use longer-dated options to protect or profit from a change in the overall trend of interest rates.
The Dividend FactorA few readers asked how iShares handle or account for dividends. Here's the official response from Barclay's:
"iShares portfolios managers operate under a mandate to track, as closely as possible, the price and yield performance, before fees and expenses, of target indexes. That includes generating a comparable dividend stream. But an index is an unmanaged mathematical construct, not an actual portfolio. Actual portfolios cost money to operate; indexes do not. Cash received in a fund portfolio is first applied against current liabilities or expenses. Depending upon the index mandate, remaining cash is either 'banked' to fund future fund dividends, or reinvested in the portfolio."Bottom line? You won't be receiving a dividend distribution. The income earned on the bond fund is calculated monthly as part of the fund's total return. So given the transaction fees relative to the extremely low rates offered, these products should not be used for short-term income generation.