Mint Explainer: What is short selling and why is it in the news again?

Sebi issued the circular after the Supreme Court asked it to investigate whether any short positions were created in breach of the law ahead of Hindenburg Research’s report last year, which alleged that the Adani Group had violated stock market rules to conduct “the largest con in corporate history”.

Mint explains short selling, its pros and cons, and the rules governing it in India.

What is short selling?

The most common way investors look to make money is simple – buy a stock whose price you expect to increase over time and sell it later, hopefully for a profit. This is called “going long” on a stock.

Short selling is the exact opposite – it is a bet that the stock will fall, not rise. Short selling or “shorting” a stock is when a trader borrows shares from a broker and immediately sells them with the expectation that the price will soon fall. If it does, the trader can buy the shares back for less, return them to the broker and pocket the difference (minus any loan interest).

What’s the purpose?

Large institutional investors and wealthy investors use short positions to hedge their portfolios. Say an institutional investor has large equity exposure to three Nifty 50 companies. There is always a risk of the stock prices going down. To reduce this risk, the investor takes short positions on the three stocks or on the entire Nifty 50 index to ensure if stock prices fall, the losses on his long positions will be compensated by profit from his short positions.

But investors also use short selling as a form of speculation, taking on extremely high risk in hopes of exceptional returns. This is dangerous, as short selling has the potential for unlimited losses.

What are the pros and cons?

In a traditional stock purchase, the most you can lose is what you paid for the shares, but the upside potential is theoretically limitless. When you short a stock, this is reversed. Your potential gains are capped because the stock price cannot fall below zero, but losses are theoretically unlimited because it can rise indefinitely. This makes short selling hugely controversial, especially among lawmakers and regulators.

However, proponents of short selling argue that it improves market efficiency, liquidity and price discovery by factoring negative information or sentiment into stock prices. Short selling also promotes investor scepticism and critical thinking as short sellers have a vested interest in exposing corporate malfeasance.

What are the rules around short selling in India?

Yes, but it is subject to certain restrictions. For instance, naked short selling is not allowed. Naked short selling when traders sell shares before actually obtaining them. They hope the shares will become available before the end of the clearing window so they can actually buy them shares and close out their short before the initial sale is finalised. Naked shorting is banned in the US as well.

Also, not all shares can be shorted in India. Only securities that have been allowed by the exchanges to offer futures & options (F&O) contracts are eligible for short selling. There are more than 2,000 companies listed on the NSE but only 183 are allowed to be shorted.

What are Sebi’s latest tweaks?

On Friday, Sebi said all institutional investors will now have to disclose upfront whether the order they are placing involves short selling. Retail traders will also have to disclose their short trades, but they will have until the end of the trading session to do so.

Brokers will also have to collect data on short positions and report it to the exchanges, which will publish it on their websites.

“The brokers shall be mandated to collect the details on scrip-wise short sell positions, collate the data and upload it to the stock exchanges before the commencement of trading on the following trading day. The stock exchanges shall then consolidate such information and disseminate the same on their websites for the information of the public every week. The frequency of such disclosure may be reviewed from time to time with the approval of Sebi,” the regulator said.