When we speak about short selling, do not worry, it has nothing to do with human height. It is an investment strategy where experienced investors can speculate if the price of a share can drop. Meanwhile, the investors try to capitalise on this opportunity by not purchasing the stocks to be reflected in their Demat account but borrowing it from the broker with the promise of purchasing it at a later date. The investor then sells the borrowed shares to buyers willing to pay the market price.
Before the borrowed shares must be returned, the investor is betting that the price will continue to decline so that they can purchase them at a lower cost. This is called short selling, which focuses on selling shares at a high price and buying them at a lower price.
How do investors tend to gain from short selling?
Let us understand this with an example: An investor named A, anticipates that stocks of company XYZ will decline in price from its current market share price of Rs 50 as soon the company releases its quarterly report that is expected to show dismal results. Depending on this projection, A borrows 15 XYZ stocks and short sells the stock in the market at Rs 50 per share. Just after the release of its quarterly report, the company also announces its acquisition which causes the prices to tank to Rs 30. A then decides to buy the same 15 shares at Rs 30, thereby earning an overall profit of Rs 300 (15 X {50-30}). A then gives back those stocks to the broker.
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Short selling, focuses on selling shares at a high price and buying them at a lower price.
What are the metrics that help investors to short sell?
Investors use two metrics for deciding to short sell their stocks. These are –
Days to cover ratio
Days to cover ratio is used to track the number of shares available to short in the market, relative to the regular shares a company has issued to the public that are available for trading. It is calculated by dividing the total number of shorted shares by the average trading volume of the company. For instance, if investors have sold or shorted 100 shares, and the average trading volume is 50 then, the days to cover ratio is 2 days (100/50).
The ratio gives a rough estimate to the sellers about the demand for stocks and when they should exit after selling. A high ratio means the stocks have a bearish trend and are most targeted shares to short.
Short interest ratio
It shows the relationship between the numbers of stocks that are shorted and the numbers of stocks that are currently issued in the market. A high short interest ratio means that the stock price will fall in the future.
Is short selling illegal in India?
In 2001, the capital market regulator Securities and Exchange Board of India (SEBI) had banned short selling in the Indian securities market 2001. But, the ban was short-lived, and short selling of stock was opened for the retail investors only.
Later in 2007, SEBI allowed institutional investors and Mutual Fund houses to short sell. However, if the investors and fund houses are not able to buy back the stocks at the time of purchase, they are obligated to pay penalty charges to their broker. The broker levies charges worth 0.07 percent of the default amount per day for overnight settlement shortage of value more than Rs 5 lakhs, security deposit shortage and shortage of capital cushion.
New Guidelines of SEBI for short selling
Under SEBI’s latest framework, the institutional investors need to disclose the time when shares are purchased and mention if the transaction was a short sale. Retail investors also need to share information at the end of trading hours on the day of the transaction. Under new short selling guidelines day trading – a form of speculation where investors buy and sell shares within the same day – is also banned.
SEBI has also introduced the Securities Lending & Borrowing system, an automated, screen-based, order-matching platform through which traders would borrow stocks and complete their sales. All investors whether retail or institution are allowed to participate in the programme and execute their short sales through it.
A word for the investors
Short selling is associated with losses, as the investor is betting against the overall direction of the market. The investor can incur huge losses if the stock prices rise and stock is not limited as per the assumption of how high it can go. As the higher limit of the stock price is fixed, they can lose more than they invested.
Short selling is also time-sensitive. If trader shorts or sells stocks long before the price drop, then they might have to bear the costs associated with short selling for a prolonged period. Also, if a trader shorts stocks too late, then chances are that the stock has lived out most of the price fall.
