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Knowledge Corner

Trading Techniques-Concept of Short Selling

One of the aspects of securities markets operations that came into intense scrutiny and stringent regulatory actions is the practice of short selling or short interest. The collapse of the structured products market has severely affected the financial health of a large number of global financial institutions owing to large-scale provisioning and write-downs. This led to massive sell-off of the shares of the affected banks and financial institutions. Fears of massive short selling accentuating the sell-off that could have led to the dramatic decline of shares of financial companies have prompted regulatory agencies all over the world to look at certain aspects of short selling and come out with some pre-emptive measures. The mechanics of a short sale are somewhat complicated and the investor's risks are high so it is important that you understand the transaction before getting into it.
What does it mean to sell short?
If you sell a stock you don't own, you are selling short it means you are shorting the stock. A short seller sells a stock that he believes will fall in value. A short seller does not own the stock before he sells it. Instead, he borrows it from someone who already owns it. Later, the short seller buys back the stock he shorted and returns the stock to close out the loan. If the stock has fallen in price since he sold short, he can buy the stock back for less than he received for selling it. The difference is his profit.
Short selling allows investors to profit from falling stock prices. "Buy low, sell high" is the goal of both short selling and purchasing shares ("going long"). A short sale reverses the order of a typical stock purchase: the stock is sold first and bought later.
For example, in March 2020, Andy thinks Company ’X’ share is overvalued. He sells short 100 shares of Company ’X’ at Rs. 250 per share. The stock market crashes in April and Company ’X’ share price falls to Rs. 210 per share. Andy buys back 100 shares of Company ’X’ and closes out the short sale. Andy gains the difference between the sales proceeds and the purchase costs and pockets Rs. 4,000 from the short sale, excluding transaction costs.
Types of Short Selling
Short-sell transactions are of two types, ‘naked’ and ‘covered’:
In naked short selling, the seller sells shares he does not own, without having set aside any shares to settle the transaction. There are no borrowing fees in this transaction since he did not borrow the shares that have been sold; however, it would normally be subject to any fees that the broker requires to hold the position open. When it is time to exit the short position, the short-seller relies on the same number of shares being available, so that he can buy them back – closing the short position. Naked short selling is often used for intra-day trading, where the position is opened and then closed at some point later in the day. Also, if a market maker does not have a sufficient supply of a particular share to meet client demand then the market maker may employ naked short selling in order to meet that demand.
Covered short selling usually involves a series of transactions.
  • In the first stage, the short-seller normally borrows the number of shares that are for short selling so that they can be delivered to the buyer at settlement. The short-seller will normally get cash on delivery of the stocks.
  • In the second stage, he short-sells the shares.
  • In the third stage, which occurs at some point in the future, he buys the same number of shares so as to return them to the original lender.
  • In the fourth stage, the replacement shares are returned to the original lender and the series of transactions is complete.
In addition to the cash markets, short selling can also be carried out by using a number of different derivative instruments, although some of these methods can be hedged by selling in the cash market. For example, a short position can be taken through single stock futures, index futures, options, etc. An effective facility for securities lending and borrowing can be an important instrument in the orderly conduct of short selling.
Short selling is used to achieve various objectives in today’s markets
  • Establish a short position in a security considered to be overvalued, believing that it will be possible to buy it back more cheaply in the future. Enable dealers/market makers who do not currently hold the relevant securities in their inventory to fill customer buy orders on demand.
  • Facilitate long/short investment strategies, in which portfolios are split between long and short positions with a view to profiting from a relatively stronger performance of the long holdings vis-à-vis the short holdings.
  • Lock in an arbitrage profit when an arbitrager exploits a pricing anomaly between two related instruments by buying the ‘cheap’ one and short selling the ‘dear’ one.
  • Facilitate hedging, especially of derivative contracts, by enabling anyone exposed to a commitment to buy securities to offset their market risk by establishing a corresponding short position.
  • Balance a long position, generally for a specific purpose; e.g., protect a long interest being held for strategic reasons or because it might be fiscally disadvantageous to crystallize a profit through a long position.
  • Facilitate the movement of new securities into the market under approved procedures such as price stabilization or ‘greenshoe’ rules; e.g., when stock is sold by an issue manager or other members of a distribution syndicate to meet strong demand for securities in the knowledge that the issuer will make available additional securities to cover their ‘shorts’.
Who are Short Sellers?
The main short-sellers differ considerably from market to market. Differences are likely to reflect such factors as market microstructure (e.g., the role of market makers), liquidity (since low liquidity will tend to deter fund managers and other investors from using short selling strategically), and the nature of any restrictions on short selling activity imposed by regulators or market authorities, or under investment laws or mandates.
Market makers/principal dealers
In equity markets, where market makers play a predominant role or intermediaries commonly facilitate customer trades on a principal basis, the major intermediaries are frequently a major source (if not the major source) of short selling activity. They may go short when filling customer buy orders on demand, as part of their proprietary trading or as part of the general risk management of their inventory. Although many trading positions are covered, or largely covered, by purchases made over the rest of the trading day, liquidity providers are generally active stock borrowers too.
Hedge funds
A second major group that uses short selling is hedge funds. Hedge funds are far more active on both sides of the market (i.e., the long and the short side) than long-term institutional investors, such as pension funds. When pursuing momentum strategies, they take substantial short positions as well as long positions (though the number of short-only funds is a very small proportion of total hedge fund assets). When adopting a more market neutral approach, they utilize various long/short strategies, designed essentially to secure returns in any market conditions by correctly predicting trends in relative prices.
Mostly, major long-term fund managers (e.g., of pension and insurance funds) do not use short selling. In addition to being natural long-term holders of the securities they acquire, they are also often prohibited from making short sales, either by regulation or under the contractual or other terms governing investment policy in respect of the funds that they manage. The extent to which private investors use short selling depends both on local investment practice and culture, as well as local regulation. In some markets, there is retail demand for short selling facilities and the markets have developed services to facilitate this, in particular, through the provision by brokers or specialist houses of retail stock lending facilities. These are commonly used in, for instance, Japan, the US, and Canada. In other markets, there is less interest on the part of private investors, and brokers are disinclined to invest in the operational infrastructure they would need to support such a service.
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