Business Today

The short end of the market

Short-selling makes a comeback. It can be rewarding for investors, but there are downsides as well.

Rishi Joshi | Print Edition: January 27, 2008

In a long-awaited decision, the Securities and Exchange Board of India (SEBI) has once again allowed short-selling of stocks by all market participants. Seven years after short-selling was banned, retail and institutional investors will now have the option to go short in the cash market from February 1.

As the move looks set to reshape stock market dynamics, there are many implications for investors. For one, short-sales will bring the Indian stock markets on par with advanced markets. Until now, there were concerns that short-sales could be used to artificially depress prices—after the 2001 securities scam it was feared that a bear cartel had artificially rigged prices by excessive short-selling. This had prompted the SEBI ban on it. Analysts feel that the markets have matured enough to re-introduce short-selling.

Says BSE member Ramesh Damani: “It will make the markets more stable. Now market participants can express both views as they are allowed to go both long and short.”

Adds Manish Sonthalia, VP (Equity Strategy), Motilal Oswal: “The decision to allow short-selling is significant and will make the markets more efficient.”

First up

A short-sale, very simply, is a bearish position on a stock. In this, an investor borrows shares, promises to return them in future and sells them. If the stock price dips, the shortseller buys the shares back at a lower price, returns the shares to the owner and pockets the difference between the price at which he sold and the new lower price. SEBI’s green signal for short-selling, analysts say, is a step in the right direction.

 What is a short sale?

  • Bearish position on a stock
  • Trader sells shares without owning them
  • Shares are borrowed to settle position
  • Interest paid to stock lenders by short-sellers at market determined rates
  • Position is squared off at a lower stock price

The rules of shorting

  • Both retail and institutional investors allowed to short-sell
  • Naked short-sales not permitted
  • Securities in futures and options segment to be eligible for short-selling
  • A securities lending and borrowing (SLB) scheme to be made operational
  • SLBs to take place on automated, screen-based, order-matching platform of authorised intermediaries
  • Institutional investors to be debarred from day trading

How It Works

Seven steps to a profitable short-sale

  • Seller sells 10,000 shares of XYZ Ltd @ Rs 100 = Rs 10,00,000
  • Seller borrows 10,000 shares of XYZ from SLB @ 18% per annum for one month = Rs 15,000
    Price of XYZ after a month = Rs 80
  • Value of the repurchased 10,000 XYZ shares after a month = Rs 8,00,000
  • Price difference at the time of XYZ repurchase =
    10,00,000 . Rs 8,00,000 = Rs 2,00,000
  • Cost of borrowing shares from SLB = Rs 15,000
  • Profit from short-selling = Rs 2,00,000. Rs 15,000 = Rs 1,85,000

*Illustrative example; actual borrowing cost may differ

In a rising market, where demand for shares exceeds supply, a short-seller steps in with borrowed securities; when the markets are sliding, the short-seller squares his position by buying back the shares. This not only beefs up market liquidity but also balances the market on both sides.

The shorting code

Typically, investors short-sell when they feel that a stock is overvalued. They sell the shares hoping to buy them back at a lower price in the future. Traders also look to arbitrage between the cash and the futures market. For instance, if the spot price of a stock is higher than the futures market, they short the stock and buy in the futures market. This cannot be done at present, though reverse arbitrage is possible—buy in cash and short the futures.

The lack of short-selling in the cash market also perhaps explains the immense popularity of stock futures. In the futures segment, shortselling is permitted. This has often led to the cash market taking signals from the futures market. Explains Damani: “Very often the spot price in the cash market runs far ahead of the futures. This is partly due to the absence of short-sellers.” SEBI hopes to remove this anomaly by permitting short-sales. The move is expected to make the markets more efficient by presenting proper arbitrage opportunities between the cash and the futures market. Arbitrage funds that today buy stocks in the cash market and sell in the futures market will now be in a position to reverse arbitrage in a bearish market and help true price discovery.

To ease the process, the market regulator will shortly roll out a securities lending and borrowing mechanism (SLB) that will work on an automated, screen-based, ordermatching platform to be provided by authorised intermediaries. SEBI wants to build a vibrant stock lending and borrowing module in tandem with short-selling. Short-sellers will have to borrow securities from the SLB scheme to complete the transaction. All investors (including retail), who own shares, can participate in the SLB scheme and earn a fee for lending shares to short-sellers. Says Sonthalia: “It’s likely to be a daily borrowing and lending process where the interest charged for borrowing stocks will be based on the demand and supply of funds and securities.”

To begin with, the securities traded in the futures and options segment will be eligible for short sales. However, SEBI is still treading cautiously and will review the list of stocks eligible for short-selling regularly. No institutional investor will be allowed day trading (squaring off transactions on an intra-day basis).

Also, naked short-sales (where the seller does not deliver shares within the settlement period) will not be permitted. In a circular, SEBI says: “The stock exchanges shall frame necessary uniform deterrent provisions and take appropriate action against the brokers for failure to deliver securities at the time of settlement, which shall act as sufficient deterrent against failure to deliver.” The restriction on naked short sales is in line with similar checks in other markets and prevents manipulation through largescale, naked short-selling.

Short-sell or not?

Short-selling is rather risky. One has to be clear as to why a particular stock will not do well in the short term, and also look at the demand and supply of that particular stock. Essentially, short-selling is a tool for traders and arbitrageurs looking for opportunities in prices. Look for short-selling only if you feel the stock has run far ahead of its right valuation.

Otherwise, investors can participate in the stock-lending and borrowing system by lending shares to other short-sellers, and earn an additional income.

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