Mint Explainer: How short selling works and why it hasn't picked up in India
3 min read . Updated: 06 Feb 2023, 05:37 PM IST
Premium- Poor liquidity in stock lending & borrowing mechanism; tough to short stocks outside F&O
The report by Hindenburg Research on the Adani Group has thrown the spotlight on short selling. Short selling is legal in India, but there are various barriers for funds (including hedge funds) who want to short-sell. This has prevented the growth of active short sellers such as Hindenburg Research in India.
What is short selling?
Short selling is the selling of a stock that you do not own, in order to profit from a fall in its price. You short sell when you think that the price of a stock will go down. This is accomplished by borrowing the stock in question and returning it along with some interest at the end of your trade.
Is short selling legal in the US?
Yes; in the US, short-selling is legal and widely practised by individuals and institutions such as hedge funds. A report on Yahoo Finance suggests that US short sellers made about $300 billion profits in 2022. The S&P 500 fell by about 20% in that year, allowing short sellers to reap profits from falling stocks. However, short sellers can only short sell stocks that they have borrowed or can reasonably expect to borrow. Where do they borrow from? Brokers usually lend stocks to their clients from their own inventory, or the inventory of other clients who have signed up for the borrowing and lending programme. However, the Securities and Exchange Commission (SEC) in the US does not permit naked short selling - short selling without borrowing the stock first, except in certain limited cases such as market makers.
Is short selling legal in India?
Yes. In India, you can short sell by selling a futures contract for a stock or an index. The futures price is simply the price that the market expects the stock to settle at on a particular date (expiry date). However, you can extend your futures position by simply rolling over the contract every month. This has a cost - you have to absorb the mark-to-market losses that happen every time you roll over, and there is also a small interest payment built into the rollover. Alternatively, you can buy a ‘put option’, an instrument that limits your downside if the stock price rises but allows unlimited profits if a stock falls. However, buying a put option requires you to pay a premium amount to the seller of the put. There are roughly 200 stocks which are eligible for F&O trading. Apart from F&O, you can also indulge in short selling ‘intra-day.’ This means you can sell a position during the trading day but you must buy it back before the close of the trading session.
Why India doesn't have large short sellers?
India has limited options for short selling. It is difficult to short sell a stock that’s not in the F&O system (the top 200 stocks). There is a securities lending and borrowing or SLB system on paper. However, industry experts point out that liquidity is poor. “Most shorting happens through derivatives (futures and options) rather than the SLB mechanism. This is because the SLB mechanism has high interest rates of 1-1.5% per month and very low liquidity. There are also additional frictions and paperwork involved in SLB," said Nikhil Kamath, co-founder of Zerodha and True Beacon, an alternative asset manager. “In futures, the only cost is a roll-over cost which is much less than the SLB. But naturally, this restricts shorting to the stocks in F&O," he said. Kamath further pointed out that India’s rules don’t encourage the setting up of large hedge funds that can aggressively short sell. “Institutions such as mutual funds cannot go net short," he said. In other words, mutual funds can sell stocks that they already own in the futures market, to the extent of their holding. However, they cannot sell stocks that they don't own. Hedge funds do exist in India including Kamath’s True Beacon 1. “However, Category III AIFs have restrictions on net shorting, such as a maximum outstanding position up to 200% of the AUM of the fund," Kamath added.
Abid Hassan, co-founder and chief executive officer of Sensibull, said that retail investors are largely absent from the short selling because of the lack of awareness and psychological barriers. “Justifiably, they believe that in long run, markets should appreciate and shorting can lead to huge losses if the trades go against their positions. When buying a stock, they may have to bear the mark-to-market losses at the worst, but don’t face the risk of bearing additional liabilities. That is why retail money is usually parked in long-only strategies," Hassan said.
Jash Kriplani contributed to this story
