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Stock market: Know the pros and cons of short-selling stocks

Short-selling enables investors to make a profit when markets are falling, and even protect their portfolio by hedging against market correction on the shorted stock and other stocks in their portfolio

Therefore, it permits investors to use leverage to avail themselves of more opportunities for further investment and gain.

By Malvika Saraf and Parthajit Kayal

An investor can often bet against the rise of a stock price if he believes the share price is likely to fall. In that case, he can sell the share if he owns it and can even sell it if he doesn’t. The latter case is known as short-selling. Here he hopes that the price will fall, so that he can buy it back, and pocket the difference. This is a ‘sell high and buy low’ strategy that allows investors to make a profit even in the falling market.

Indian regulators allow investors to engage in intra-day short selling in the spot market. It is mandatory to provide delivery of shares for investors who short-sell stocks. It means all short-selling positions in the spot market have to be covered during the same day’s trading hours by buying back equivalent numbers of shares. However, investors are allowed to engage in inter-day short-selling through futures and options.

Practice of short-selling

Short-selling is practised not just by speculators, but also by arbitragers, hedgers, and traders. Short-sellers must first borrow shares on an over-the-counter securities lending market. Stocks are lent via intermediaries, which are specialised teams within financial institutions, who generally borrow the shares from custody services whose clients (e.g. insurance companies, pension funds, etc.) have authorised them to do so. Shares owners lend them out in the market in order to enhance their performance (around 25 to 50 basis points) and be rest assured that they can recover them at any given point in time.

The lending contract most often requires a guarantee from the borrower in the form of cash or shares. The amount of the guarantee is negotiated and decided upon on a case-by-case basis and is close to 100% of the shares’ value. The short-seller later buys back the shares on the market to restore them to the lender, thus unwinding the transaction and the securities loan. In the case of retail investors who don’t have access to such lending facilities, they are notionally considered to be borrowing from their brokers against cash or other shareholdings.

Advantages of short-selling

Short-selling is an approach commonly used by financial market intermediaries (eg.share brokers) as a medium for their business. It increases market liquidity and efficiency as well as helps to regulate prices, particularly for overvalued shares. Short-selling enables investors to make a profit even when markets are falling, and also helps them protect their portfolio by hedging against a market correction on the shorted stock, as well as other stocks in their portfolio. In short-selling, less money is involved and profit can be made without even having the need to own the share. Therefore, it permits investors to use leverage to avail themselves of more opportunities for further investment and gain.

The risks involved

In the case of short-selling, the risk could be unlimited. Those who are long on a stock (i.e., who have bought the stock) risk only 100% of their investment, no more. Usually, short-sellers’ risk is unlimited since the upside potential of share prices is, theoretically, infinite. Thus, a short-seller’s loss can be notably substantial if the stock price rises significantly before he is able to buy back the shares needed to cover his short position.

Again, short-selling carries delivery risk, when the short-seller is unable to restore the shares within the same day(it happens if the stock prices hit the upper circuit due to heavy demand) because he won’t be able to provide the delivery of shares during the time of settlement. In this situation, the investor’s broker would buy the share through the auction market on behalf of the investor (at a much higher price, in most cases). Further, investors are required to pay a hefty penalty charge to the clearing member for defaulting.

Overall, short-selling contributes to the financial markets’ functioning in many ways. It increases market efficiency and helps investors use the strategy for hedging, speculation, etc. To effectively use short-selling, investors should have a sound understanding of market dynamics like direction, volume, liquidity, volatility, etc. Knowledge of technical analysis can be added advantage to understand this better. Retail investors with limited knowledge about the same should refrain from short-selling to avoid unnecessary large risk exposure.

Saraf is a recent graduate of Madras School of Economics and Kayal is assistant professor, Madras School of Economics

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