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What is Shorting? How to Short a Stock in India?

Co-Founder & Head of Business, Transfin.
Apr 10, 2020 7:45 AM 5 min read
Editorial

Often touted as the "dark side" of the market, shorting (or short selling) has over time gained some kind of recognition in popular culture, thanks to movies such as Adam McKay's The Big Short or documentaries like The China Hustle

 

So, what is shorting and why does it have this rather dubious reputation? How to short a stock in India? What are the SEBI short selling rules? Well, let's dig in.  

  

  

WHAT IS SHORTING

Short selling (or “Shorting”) is defined as selling a stock in the share market which the seller does not own at the time of trade with the hope of buying it back later at a lower price and thus making a profit.

 

It is this “Sell First – Buy Later” format which appears to be somewhat counter-intuitive. How can you sell something that you don’t own?

 

Well, you borrow!

 

Before getting into the borrowing mechanics, let's take a closer look at

  1. Buy First – Sell Later or "Going Long"
  2. Sell First – Buy Later or "Shorting"

 

Buy First - Sell Later or "Going Long"

When a trader/investor believes that the price of a stock is expected to rise in the share market, he/she will buy the stock with the hope of selling it later at a higher price and thus pocketing the profit. While this is fairly intuitive, an illustrated trade fortifies the mechanics. 

 

1. Let us assume you buy HDFC stock for ₹1,000

2. Let’s say HDFC stock moves up to ₹1,500 and you sell it

3. You make a pre-tax gain of ₹500

Note: This will warrant a short-term capital gains tax of 15%.

 

A short-seller on the other hand is making an opposite bet!

 

Why Shorting gets somewhat murky?
Shorting can get murky

 

Sell First - Buy Later or "Shorting"

When a trader/investor believes that the price of the stock is expected to decline in the share market, he/she will sell the stock first with the hope of buying it back later at a lower price and thus pocketing the profit.

 

1. Let us assume you short HDFC stock for ₹1,000

2. Let’s say HDFC stock moves down to ₹500 and you buy it then

3. You make a pre-tax gain of ₹500

Note: This will warrant a short-term capital gains tax of 15% on it.

 

Here’s why Shorting gets somewhat murky. The trader/investor doesn’t own the stock in the first place so how can he/she sell first? The answer to this as alluded to earlier: the trader/investor "borrows" the stock from the brokerage who in turn borrows from the clearing house or from a clients portfolio. 

 

Borrowing is a prerequisite to Shorting

The principle of Shorting is underpinned by the trader/investor "borrowing' something that they do not own. This then leads to a series of subsequent actions to close the trade, as illustrated below: 

 

 

Step-by-step process of Short Selling
Step-by-step process of Short Selling

 

WHY DOES SHORTING HEIGHTEN YOUR RISK PROFILE?

Shorting comes with meaningful risk implications and in that context, tends to attract heightened regulatory oversight. Revisiting the aforementioned transactions is perhaps the best way to understand the unique risk-profile that Shorting carries. However, this time we'll assume things don't go as per plan.

 

1. Again, let's assume you short HDFC stock for ₹1,000

2. Let’s say HDFC stock moves up and keeps moving up!

3. Your potential losses are infinite! (there is no upper limit for a stock price)

 

Compare this to the less riskier - Going Long, where

 

1. You buy HDFC stock for ₹1,000.

2. HDFC stock moves down to ₹0!

3. Your loss is capped at ₹1,000 (₹0 being the lowest possible stock price!)

 

The uncapped and potentially unlimited loss profile associated with Shorting is what makes it such a risky proposition.

 

You don’t want to be left holding an obligation to give back the stock to the clearing house (the one you borrowed and shorted) while the price keeps going up. In fact this is why brokerages ask for some margin requirement to cover the potential liability. 

 

SEBI SHORT SELLING RULES IN INDIA

In India, a key regulatory restriction associated with Shorting is that the trader/investor or investor shorting a stock is mandated to buy back the shares and implicitly “square off” the position at the time of settlement i.e. Before stock market closing. Consequently, you can short stocks in the spot market only on an intra-day basis. Said another way, your ‘short position’ is restricted to one day - a substantial limitation for a bearish bet (unless you short via derivative products like futures or options)!

 

Short-selling caught a lot of international debate and attention last year in light of Elon Musk and Tesla. Tesla was one of the most shorted stocks and as one would suspect, Elon Musk wasn't too pleased (tweet).

 

Elon Musk doesn't like Short Sellers
Elon Musk doesn't like Short Sellers. Well, duh!

 

IMPACT OF COVID-19 ON SHORTING

Global financial markets across the world are currently cracking and cracking hard. COVID-19 driven negative sentiment continues to drive extreme bearishness and heightened volatility. Consequently, it is unsurprising to see market watch dogs across the world deploy a myriad of conventional and unconventional measures to manage risk.

 

In that context, SEBI recently outlined sharp steps to manage "shorting-driven" market risk which are designed largely to discourage investors and traders from constructing massive short positions. While we will save deeper-dives into each of those steps for some time later, here’s a succinct but somewhat technical outline.

 

FIN.

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