THE SECURITIES and Exchange Board of India (SEBI), vide its circular MRD/DoP/SE/Dep/Cir-14/2007 dated 20/12/2007 has allowed short selling of shares in the Indian stock market. Short selling by all classes of investors, retail as well as institutional, has been permitted.

Until now you were able to sell shares only if you held them in your demat account. Suppose you believe that the price of RNRL share will fall today, you can sell the said share even if you don’t hold it and still make some money. This is the beauty of short selling. In a nutshell, selling before owning a share is called short selling. It means you owe the share to the buyer and you can sell it all the same. But mind, you may make money or lose money too!

Making money through short selling

Suppose RNRL shares are available in the market at Rs 160 per share. Now you expect its price to go down to Rs 100 per share. As a short seller, you will borrow immediately 100 shares of RNRL at Rs 160 per share and sell them at that price in the morning. Suppose when the market closes, the share price falls to Rs 100 as you anticipated. You will have earned Rs 6,000 as the following paragraph explains:

When the price falls to Rs 100 per share, you will purchase 100 shares of RNRL. It will cost you Rs 10,000. Deliver the 100 shares to the person you sold it to in the morning and collect Rs 16,000 from him. Out of this 16,000, pay Rs 10,000 to the person you bought the 100 shares from. You will have made a profit of Rs 6,000 (16,000-10,000). This is interesting since without blocking your money you have made a profit. Of course, the extent to which every investor can go short (in terms of money) will be laid down by the exchange.

Downside risk of potential loss

The flip side of short selling is that the investor can lose too. Suppose the price of RNRL share closed at Rs 200 per share (instead of closing at Rs 100 per share, as you anticipated). You will lose because you have to purchase each share for Rs 200 which will cost you Rs 20,000 (200*100). When you deliver the shares to the buyer, you will receive Rs 16,000 only (at Rs 160 per share, as agreed upon) and thus will incur a loss of Rs 4,000 (20000-16000).

Benefits that accrue to investors from short selling

• Rotation of limited money: Once a limit is fixed for short selling with the broker and the prescribed margin deposited (the money which the short seller is supposed to bring in), investors can take ample exposure. Those who do their homework and invest intelligently will benefit from short selling. But the entire cycle needs lots of investment technique.
  

• Minimum liquidity: In the short selling exercise, the investor needs to pay or receive only the difference between the buying and selling price. This implies the investor requires minimum liquidity.
  

• Potential benefits: The upside potential offered by short selling is theoretically unlimited. But the circuit filter applied by stock exchanges limits the gains. However, investors not allotted shares during the initial public offer (IPO) will gain if the share price falls immediately upon listing. Many a time, some IPOs are priced aggressively but list on the stock exchange at a lower price (as in the case of Cairn India shares).
  

• Good for bears: Short-selling involves betting on falling prices and hence it suits investors with bearish temperament.
  

Short selling is said to play a positive role in the stock market. Sometimes, it works as a price discovery mechanism which helps in identifying the over-priced stocks. Collated information concerning a short-sold stock acts as a signal of the price movement concerning that stock.

By permitting all types of investors to undertake short-selling, SEBI has tried to increase the width of the market. In Western countries, short selling has been in vogue for quite some time. Apart from increasing the width of the market, short selling can lead to excessive speculation. Short selling has been instrumental in avoiding crashes in a bull market. Since short selling bets that stock price will decline, it provides a voice of reason when a bull market is raging. It appears that in the booming bull market of India, SEBI has chosen a preventive mechanism to avert any potential crash of the market.