14.9 Short selling

Hanumant Dhokle

Short selling is one of the short-term trading strategies. Suppose you are absolutely sure that a stock is going to decline and you want to profit from its regrettable demise. What should be your mode of action? How can you cash in on such a situation? Short selling is an investment strategy where you could increase your value of portfolio during a bear market. Many investors make money on a decline in an individual stock or during a bear market, thanks to an investing technique called short selling .

It is a very simple concept. But it's a concept where most of the investors have trouble understanding. That is because people generally believe that you cannot sell something which you do not have. In a way it is right. In normal situations people buy an asset, hold it to appreciate in value and then sell it off for a profit. But short selling is the opposite since an investor makes money only when a shorted security falls in value.

What Is Short Selling?

First, let's describe what is short selling. Usually you trade through a broker with the help of a trading account which is a cash or margin account. In normal transactions an investor buys a share believing that its price will rise in the future. But when an investor goes on short he or she is anticipating a decrease in the share price.

Investors execute short selling for two reasons:

  1. When they feel the price of a stock is overvalued, they go short on that stock, expecting the prices to come down. Short sellers hope to buy back the stock at a lower level and
  2. Traders also prefer to go short on the cash market when the spot price of a stock is higher than the futures (derivatives) prices. Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but one that is promised to be delivered. That may sound confusing, but it's actually a simple concept. When you short sell a stock, your broker will lend it to you. The stock will come from the brokerage’s own inventory, from another one of the firm's customers, or from another brokerage firm. When the shares are sold, the proceeds are credited to you. However, you must 'close' the short by buying back the same number of shares (in other words, this is called covering) and return them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money. For example, Mr Mahesh is sure that the stock price of a particular scrip is going to fall. So how can he make money out of the potential fall of this share price? Suppose IVRCL is selling today at Rs250. So he can sell 100 shares of IVRCL which will fetch him Rs25,000. Later in the day, the share price of IVRCL falls to 220. Now you can decide to buy back those shares at that rate and your cost for the same is just Rs22,000. So what is your profit? It's Rs3,000 in a falling market. Sounds good? Most of the time you can hold a short for as long as you want, although interest is charged on margin accounts and so keeping a short sale open for a long time will cost more. However, you can be forced to cover if the lender wants back the stock you have borrowed. Brokerages can't sell what they don't have, so yours will either have to come up with new shares to borrow, or you will have to cover. This is known as being 'called away'. It doesn’t happen often, but is possible if many investors are short selling a particular security.

Since you don't own the stock you are short selling (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. In India, the Securities and Exchange Board of India (SEBI) in 2007 allowed short selling of shares by all classes of investors, both institutional and retail. Short selling had been banned by the regulator in the wake of the Ketan Parekh scam in 2001. Naked short selling, or naked shorting, is the practice of selling a financial instrument short without first borrowing the security or ensuring that the security can be borrowed as is done in a conventional short sale. When the seller does not obtain the shares within the required time frame, the result is known as 'fail to deliver'. The transaction generally remains open until the shares are acquired by the seller, or the seller’s broker, allowing the trade to be settled. Naked short selling can be used to manipulate the price of securities by driving their price down, and its use in this way is illegal.

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