Monday, August 18, 2008

Short Selling/Short Position


Yesterday our C.R. Mr. Pradeep asked me to write about short selling. So today I am sharing & some basics of short selling/short position with you guys.

When I was doing my SIP (Summer Internship Program), most of the time I used to do short selling because at that point of time market was cracking down. In simple terms, short selling is reverse process of normal trading. In normal trading we buy @ lower value and sell @ higher value (long position). In this type you expect market to bullish. But when you think market may be bearish then go for short selling. Means sell @ higher value and buy @ lower value. In shorting we sell the shares without owning them, so we have to buy back the shares within the stipulated time.

In short selling there are two different types, one is for intraday and another one is for long term.

Intraday short position doesn’t affect the market sentiments much. Since most of the time intraday shorting is done by retail investors. And in this intraday case you have to buy back the share whatever you sold earlier otherwise exchange will auction the share and have to pay penalty.

Where as, FIIs, HNIs and some experienced retail investors usually take long term short position. For long term short position, we have to use F & O. Since I have very limited knowledge theoretical knowledge (Not traded in F&O till now), I will not in position to give much of inputs. But I can say that, to take long position you have to buy the put option for that particular month. And the end of the month you have square off your position by buying back the shares or you have to roll over for the next month. Same procedure applies to future with slight variations.

In present condition of the market, most of the players are using the short position as their trading. Market move can be identified by call/put ratio. Most of the time, this pull back rally in bearish market is because of square of short position.

How it works???

Unlike a normal transaction, which involves two parties (the buyer and the seller), short selling involves three parties: the original owner, the short seller, and the new buyer. The short seller borrows shares from the original owner at the time short selling & sells them on the open market to any willing buyer. To finalize the short sale transaction, the short seller must then go out into the stock market and buy the same amount of shares as he sold so that the broker can return them to the original owner.

To sell short you first must set up a margin account with your broker. A margin account allows you borrow from your brokerage company using the value of your portfolio as collateral. The general rule is that the value of your portfolio must equal at least 50% of the size of the short sale transaction. In other words, if you have Rs. 100,000 worth of stock/cash in your margin account, you can borrow Rs. 200,000 of stock to sell short.

To sell a stock short, you must borrow stock. To initiate a short sale, you simply call up your broker and ask to sell short a specific number of shares of your selected stock. Your broker then checks with the Margin Department to see whether the shares are available or can be borrowed. If they are available, the brokerage borrows (from other customers or stock holding corporation of India on behalf of you) the shares, sells them in the open market. To close out your short sale, you tell your broker that you want to buy the same number of shares that you shorted. The broker will purchase the shares for you using the money in your margin account, return the shares and close out the short sale transaction.

Difference between covered and naked short sales

Covered short sales are those in which the seller arranges for the delivery of shares he has sold by borrowing them. Naked short sales are those in which the seller does not intend to provide for the delivery of shares he has sold. Most international securities market regulators have prohibited naked short-selling and require the client to have documentary evidence of borrowing/tie-up with lenders before executing the sale transaction. This is because naked short sales in huge quantities can destabilize the market.

Drawbacks of short-selling

Critics of short-selling feel, selling directly or indirectly, poses potential risks and can easily destabilize the market. They believe that short-selling can exacerbate declining trend in share prices, increase share price volatility, and force the price of individual stocks down to levels that might not otherwise be reached. They also argue that declining trend in the share prices of a company can even impact its fund raising capability and undermine the commercial confidence of the company. In a bear market in particular, short-selling can contribute to disorderly trading, give rise to heightened short-term price volatility and could be used in manipulative trading strategies.

SEBI framework for short selling

1. Naked short selling shall not be permitted in the Indian securities market and accordingly, all investors would be required to mandatory honor their obligation of delivering the securities at the time of settlement.

2. No institutional investor shall be allowed to do day trading i.e., square-off their transactions intra-day. In other words, all transactions would be grossed for institutional investors at the custodians’ level and the institutions would be required to fulfill their obligations on a gross basis. The custodians, however, would continue to settle their deliveries on a net basis with the stock exchanges.

3. 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 a sufficient deterrent against failure to deliver.

4. The securities traded in F&O segment shall be eligible for short selling. SEBI may review the list of stocks that are eligible for short selling transactions from time to time.

5. The institutional investors shall disclose upfront at the time of placement of order whether the transaction is a short sale. However, retail investors would be permitted to make a similar disclosure by the end of the trading hours on the transaction day.

6. The brokers shall be mandated to collect the details on scrip-wise short sell positions, collate the data and upload it to the stock exchanges before the commencement of trading on the following trading day. The stock exchanges shall then consolidate such information and disseminate the same on their websites for the information of the public on a weekly basis. The frequency of such disclosure may be reviewed from time to time with the approval of SEBI.


1 comment:

Anonymous said...

Naveen it is a good write up on short selling as it gives an overview of what short selling is. Talking about Covered and Naked Short sales (what i have read) the Covered short sales means the seller has the possession of the shares what he intend to sell(or the short sell is backed up the shares held) while in case of naked short sell he don't have the possession of the shares he have to arrange for it (or the short sale is not backed up by the shares held). Its not about the intention of the seller because anyhow the delivery has to be made to the buyer either by incurring loss by the seller or by Auction.