Short-selling: Profit from the bad news

Short-selling: Profit from the bad news

Short-selling, the practice of selling a stock that you do not own, and making profit when the price falls, is not new in India. Retail investors have been doing it in the spot market for long. However, there were no proper procedures to execute and regulate the transactions.

Not any more though. Starting Monday, 21 April, a new set of guidelines and procedures, for both institutional and retail investors, have been put in place by market regulator Securities and Exchange Board of India (Sebi), stock exchanges and brokers, to execute the transaction.

The conventional way of profiting from the market is by buying a stock at a lower price and selling it when the price is higher. The same rule applies in short sales as well, but with a difference. The transactions here happen in the reverse order—the shares are sold first, without actually owning them. The sales are covered later by purchasing the shares when their prices fall.

Betting right on negative news—events that can pull a stock down—is what earns the profit. Of course, an increase in the price would result in a loss to the short-seller.

So far, retail investors had to cover the shares they sold short—that is, without owning them—by the end of the day they execute the transaction. The new system provides for borrowing shares for a seven-day period and using them to settle the sale of shares within a T+2 (trading day + two days) deadline. The stock exchanges will give an automated platform for an hour everyday to facilitate borrowing and lending of shares, and you will be allowed to sell short only after you enter into a deal to borrow the shares. Till now, the lack of a proper system to borrow shares was a big impediment for short-selling. Understandably, short-sellers are not very popular and are often accused of causing huge market fluctuations. But, they are also credited as the ones who ring the warning bells—they trade on expecting negative news. James Chanos, the hedge fund manager who profited by anticipating the fall of Enron Corp., said during a hearing on the US energy giant’s collapse: “While short-sellers probably will never be popular on Wall Street, they often are the ones wearing the white hats when it comes to looking for and identifying the bad guys." And, for you, betting on the bad news would require continuous monitoring of the market and the events that affect it.

We give you answers to some frequently asked questions on short-selling:

Can I sell short any stock listed on a stock exchange?

Initially, short-selling will be permitted only in 227 stocks that are also traded in the futures and options segment, where deals can be entered into for making transactions at a future date. Later, the stock exchanges may decide to extend short-selling to a larger universe of stocks.

Will my current broker provide the facility to short-sell the stocks or do I need to register with a new broker?

Brokers will have to enter into an agreement with stock exchanges’ clearinghouses—Bank of India Shareholding Ltd for the Bombay Stock Exchange and National Securities Clearing Corp. for the National Stock Exchange— for offering the facility. If your current broker hasn’t put in place the required systems and processes, then you may have to sign up with a new broker. But, competitive pressure may force all brokers to provide the facility to their clients.

Can I sell stocks that I don’t own?

You can. You can give delivery of the shares to the buyer by borrowing them from other investors who are willing to lend the shares. But, you need to enter into a deal to borrow the shares before you sell them short.

Retail investors need to inform their brokers about the short sale they entered into before the end of the trading hours. Institutional investors will have to inform the broker upfront, if they are selling short.

How do I borrow and lend stocks?

You need to first enter into an agreement with your broker that will specify the terms and conditions of the stock borrowing and lending transaction. Brokers may put such terms and clauses to ensure that you do not default in any lending or borrowing transaction.

On every trading day, there will be a one-hour trading session between 10am and 11am where lenders and borrowers of shares can try to match their orders through a trading screen. So, if you want to borrow 100 shares of company X, your broker will find an investor who will be willing to lend the same number of shares in that company. After you put the order for borrowing the shares during the one-hour trading session, you will get the shares the next day. You can keep the shares for seven days and then return, often by buying the shares from the market.

What fees do I have to pay for borrowing shares? Can I earn quick returns by lending my shares?

Lending and borrowing of shares will happen at a price, which will be determined by the market. In other words, it will depend on the number of borrowers and lenders available for a particular stock. For example, if you want to borrow shares of company X at Rs10 per share as the borrowing price and if there are lenders at the same price, your transaction will be done. If the lenders quote Rs15, you can ask your broker to negotiate a deal. The lending and borrowing costs will also depend on the previous day’s closing price of that stock.

Besides this cost, the borrower will have to ensure that he has enough funds to pay the margin; this is to safeguard the interests of the lenders.

Long-term investors can earn short-term income by lending shares. But mind you, it won’t be a completely risk-free way. If the borrower is unable to return the shares after seven days, then the exchange will carry out a buy auction to ensure that you get the shares. If the shares can’t be bought through the auction, then the exchange will compensate you for the value of shares you lent. The value of shares will be computed according to a certain formulae, which will take into account the market price of the shares.

Do I have to pay tax on the income I earn by lending shares?

Tax authorities have said that lending and borrowing transactions will not be considered as a transfer of securities and hence, it will be exempt from capital gains tax and the securities transaction tax.

What are the measures to prevent selling short to pull down a stock or the market?

The brokers will have to assign a unique client identification number to each investor who wants to participate in the lending and borrowing of shares. The identification number will be mapped to the investor’s permanent income-tax account number, so that any effort to manipulate stock price can be tracked. The stock exchanges may levy stiff penalties on brokers for violation of this rule. As there will be limits on what percentage of each company’s shares can be borrowed or lent, there won’t be much scope for any investor to short-sell stocks through multiple brokers.

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