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Information on Short Selling

 

The Security and Exchange Board of India [Sebis] has allowed short-selling and security lending and borrowing from April 2I, 2OO8. In view of above u might want to know few basics of short selling.

What is short selling?

Short-selling, in context of share market, is practice where an investor sells shares that he doesn't own at time of selling them. He sells them in hope that price of those shares will decline, and he'll profit by buying back those shares at lower price.

How is short-selling beneficial?

Short-selling is considered an essential feature of security market not just for providing liquidity, but also for helping price corrections in over valued shares.

Supporters of short-selling claim its absence distort efficient price discovery, gives promoters unfettered freedom to manipulate prices and favors manipulators than rational investors.

Security market regulators in most countries, and in particular, all developed security markets, recognize short-selling as legitimate investment activity. The International Organization of Security Commissions [IOSCOs] has also reviewed short-selling and security lending practices across markets and has recommended transparency of short-selling, rather than prohibit it.

What are drawbacks of short-selling?

Critics of short-selling feel selling, directly or indirectly, poses potential risks and can easily destabilize market. They believe that short-selling can accelerate declining trend in stock prices, increase stock price volatility, and force price of individual shares down to levels that mightn't otherwise be reached.

They also argue that declining trend in stock prices of Comp. can even impact its fund raising capability and undermine commercial confidence of company. In a bear market in particular, short-selling can contribute to disorderly trading, give rise to heightened short-term price volatility and could be used in manipulative trading strategies.

SEBI HAS ALLOWED SHORT SELLING FROM APRIL 2I, 2OO8

Sebi had come out with circular on December 2O, 2OO7, specifying broad framework for short selling by institutional investors and full-fledged security lending and borrowing scheme for all market participants. According to Sebi move was aimed at protecting interests of investors in security and to promote development of, and to regulate security market. The regulator also said that funds will need to start paying margins upfront along with other investors

“In order to provide level-playing field to all investors in cash market as in case of derivatives market, aforesaid circular is partially modified to provide that all institutional trades in cash market would be subject to payment of margins as applicable to transactions of other investors,” regulator said.

The measure will take effect in two phases.

“To begin with, from April 2I, 2OO8, all institutional trades in cash market would be margined on T+I basis with margin being collected from custodian upon confirmation of trade,” regulator said. “Subsequently, with effect from June I6, 2OO8, collection of margins would move to an upfront basis.”

The nation’s share exchanges has issued necessary guidelines and put in place necessary systems to ensure operationalization of measure, regulator said.

Short selling in share markets

Recently there was lot of debate in share markets and media about short selling and if it should be banned in view of volatile global financial turmoil. For those new to stock markets and share market investing here is brief look at what exactly short selling means and how it affects the stock markets. 

Short selling means  the selling of financial assets or security [stocks, bonds] that don't belong to person selling it but have been borrowed generally from broker or a brokerage firm Short selling works on premise of making money over fall in price of asset. The process can be explained using example of shares. There are always certain shares in market, which are overvalued and overpriced owing to different reasons. A short seller predominantly looks out for such shares, which are sooner or later, expected to see fall in their prices. 

The short seller then borrows these shares from lender and sells them when prices are still high. The short seller then waits for prices to dip after which he buys back same stock and returns it to lender. The short seller thus makes profit as he manages to buy share back at rate, which is lesser than what he makes out of the sale of share.

Short selling is regulated by share market regulators and certain rules of share exchange depending on country.

Most country have strict regulations on short selling including restrictions regarding type of assets that can be sold and time period within which this trading activity needs to be performed. If there are any dividends or rights that come from share during course of the loan, short seller needs to pay these back to lender.

You can also need to open margin Acc. to indulge in short selling. However, u will need to remember that in addition to being profitable, short selling is also very risky. While short sellers use many ratios to predict whether price of asset will fall, there is always chance that prices can see hike, which can bring considerable losses to short seller.

Ban on short selling in US

The Security and Exchange Commission, which acts as financial regulator in US banned short selling of financial shares on September I9 as they felt that it's contributed towards fall in share prices of the banks and could aggravate financial crisis. 

This was as an attempt at boosting confidence of investors in security market. However, ban came to an end on October 8. Market regulators in country like UK and Australia have also introduced bans on short selling.

Short selling in India

Short selling was practiced in India till 2OOI but was banned by SEBI, after Ketan Parekh scam. It was revived early this year. In India, now both retail and institutional investors are allowed to indulge in short selling.

Despite bans in different parts of world, SEBI has declined need for ban on short selling in India.

 


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