Modeling Stock Borrow Costs in Short-Selling Backtests

Summary

The document addresses how to represent short-sale constraints in a backtest. Its proposed control is to include a borrowing cost for short positions, since live shorting generally requires shares to be borrowed through a broker. The cost can be included in transaction costs or incorporated into the factor model, so the strategy’s expected returns reflect the expense of maintaining shorts.

A simple approximation is to make short trades more expensive than long trades by an added percentage. The answer cautions that this adjustment could eliminate projected profits. It also suggests using historical short interest as an indicator of potential borrow difficulty: high demand to short a stock may correspond to a higher borrowing cost. The document gives no calibrated cost formula, historical example, or comparison of alternative controls. Short interest is presented as a rough estimation aid, not a direct measurement of the stock loan fee, and the proposed percentage adjustment may not capture security-specific availability or changing borrow rates.

Key ideas

• Backtests with short positions should account for the cost of borrowing shares.
• Borrow costs can be represented in transaction costs or within a factor model.
• A simple approximation is to apply an additional cost to short trades.
• Historical short interest may help indicate when borrowing costs are elevated.
• Borrow costs can materially reduce or eliminate projected strategy returns.

Tags

# Limits on Short selling


# Limits on Short selling












When back testing an algorithm that relies upon short selling certain stocks, how to limit the short selling so that the back-test results still remain reliable? What kind of controls are generally put on such algorithms during actual trading and how to simulate such controls while backtesting?

## Answer by Luke (score 3)

https://quant.stackexchange.com/a/17302

You should make your borrow cost sufficient to dissuade unlimited short selling. In practice, each short would require you to borrow shares from your broker. This is usually handled when computing transaction cost. You should account for this in your trading algorithm or in the factor model itself. A simple method would make shorts some N% more expensive than longs. In practice, this could kill your projected returns. You could probably estimate this factor by looking at historical short interest on the stock. If everyone is trying to short it, the cost to borrow is going to be high.

http://www.investopedia.com/terms/s/stock-loan-fee.asp

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.