What Is Short Selling?

Investors who are experienced probably know a thing or two about short selling. But if you're a novice investor, you may be scratching your head and wondering about this concept. Rest assured, it has nothing to do with your height. Short selling is the sale of a security that is borrowed by the seller, which means they don't own it.

The sale comes with the promise to buy back the shares at a later date. Short selling is motivated by the belief that a security's price will decline, which enables it to be purchased in the future at a lower price to make a profit. The opposite of traditional capital gains investing, this strategy only pays off when, and if, the security drops in value from the date of sale to the date of repayment.

Opponents argue that short selling leads to market declines and recessions. They believe widespread short selling can trigger a sale spiral, crashing the market and damaging the economy. Opponents also claim it leads to manipulation and efforts to artificially dampen prices of certain equities.

Other critics suggest using a ban on short sales as a pseudo-floor on stock prices. These are some of the reasons why a country might ban short selling. This article examines short selling in India, one of the fastest-growing economies in the world.

key Takeaways

  • Short selling involves the sale of a borrowed security with the intention of purchasing it again at a later date at a lower price.
  • The practice was banned by the Securities and Exchange Board of India between 2001 and 2008 after insider trading allegations led to a crash in stock prices.
  • Financial authorities require traders to identify short sales at the time of the order.
  • Naked short selling remains illegal in India, along with day trading by institutional investors.
  • Indian regulators instituted a temporary ban on short selling between March 2020 and October 2020 because of economic turmoil of that year.

India's Ban on Short Selling

Short selling was banned for much of the first decade of the 21st century in the South Asian nation It was suspended in the Indian stock market by the Securities and Exchange Board of India (SEBI) in March 2001.

The ban was instituted partly because of a crash in stock prices amid allegations that Anand Rathi, the then-president of the Bombay Stock Exchange (BSE), used confidential information acquired by the exchange's surveillance department to make gains and contribute to volatility. Rathi was later absolved of any wrongdoing by SEBI.

The all-out ban on short-selling was short-lived. Retail investors were allowed to short sell after the ban of 2001. SEBI recommended that institutional investors, such as mutual funds, be allowed to short sell shares in the market in 2005.

New Short Selling Guidelines

SEBI issued short-selling guidelines for institutional investors in July 2007. Seven years after short selling was banned, both retail and institutional investors had the option to go short in 2008.

Under the new framework, institutional investors were required to disclose upfront at the time the order was placed whether the transaction was a short sale. Retail investors had to make a similar disclosure by the end of trading hours on the day of the transaction. Day trading was also banned for institutional investors under the new short-selling guidelines.

SEBI also introduced the Securities Lending & Borrowing system, an automated, screen-based, order-matching platform through which traders would borrow stocks and honor their sales. All classes of investors were allowed (and, in fact, encouraged) to participate in the program and execute their short sales through it.

Day trading involves the squaring off of transactions on an intra-day basis.

No Naked Short Selling

Even though Indian authorities lifted the restrictions on short selling, naked shorting remains illegal. This occurs where the seller doesn't deliver shares within the settlement period. All investors were required to honor their obligation of delivering the shorted securities at the time of settlement.

"The stock exchanges shall frame necessary uniform deterrent provisions and take appropriate action against the brokers for failure to deliver securities at the time of settlement, which shall act as sufficient deterrent against failure to deliver," according to a note published by SEBI.

150

The approximate number of securities traded in the futures and option (F&O) segment of the Indian stock market eligible for short selling.

Special Considerations

Indian securities regulators instituted a temporary ban on short-selling once again in March 2020 due to the 2020 crisis. They were among some of the world's financial authorities concerned about how short selling would affect the stability of the financial markets. Regulators justified the ban, saying it would keep markets operating in a fair, efficient, and orderly fashion. The ban was in effect until October 2020.

The Bottom Line

Short selling can be a great way for investors to maximize their profits. But critics say this strategy can lead to problems within the market. While the United States has more liberal views of short selling, countries like India have gone so far as the ban the practice. India restricted short selling for the seven-year period between 2001 and 2008 and again in 2020. And it continues to ban naked short selling. Authorities say it helps keep the market fair for all participants.