Effects of illegal insider trading

Here is how it impacts the stock market:

Unfair for other investors

Individuals who have such inside information can potentially make larger profits from the stock market than a typical investor who is devoid of such knowledge. 

It is unethical

Does not give investors equal opportunities of earning with the same piece of information about the company. 

Hampers investor’s confidence

Investors spend time and effort while investing in stocks. With insider trading, investors will not get the opportunity to make any money which eventually results in eroding their trust to trade in stock markets. 

SEBI’s amendment to curb insider trading 

The frauds committed by Harshad Mehta led to the establishment of a strong regulator, Securities, and Exchange Board of India (SEBI) by the government with the passing of the SEBI Act 1992.

In January 2019, SEBI introduced a new amendment under ‘ Prohibition of Insider Trading’. The new amendment holds all those promoters irrespective of their shareholding status to be violating insider trading norms who possess non-published price sensitive information (UPSI) of a company without any legitimate purpose. 

The legitimate purpose will include sharing of the non-published price-sensitive information (UPSI) in the ordinary course of business by an insider with partners, collaborators, lenders, customers, suppliers, merchant bankers, legal advisors, auditors, insolvency professionals or other advisors or consultants, provided that such sharing has not been carried out to evade or circumvent the prohibitions of these regulations.

Recently, SEBI has penalised six individuals by charging a fine of Rs 1 lakh to each for violating insider trading norms in the matter of Titan Company Ltd. The total traded value of the securities by each of them was over Rs 10 lakh.

What lies ahead for the investors?

Investors should never engage in this kind of insider stock market trading and committing such malpractices will attract considerable fines and even federal prison sentences under Indian Law.

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.