Explainer: How short selling works and why it’s not taking off in India

What is short selling?

Short selling is the sale of a stock that you do not own in order to profit from a decline in its price. You short sell when you think the price of a stock will go down. This is accomplished by borrowing the stock in question and returning it with some interest at the end of your trade.

Is Short Selling Legal in the US?

Yes; In the US, short-selling is legal and widely practiced by individuals and institutions such as hedge funds. A report by Yahoo Finance suggests that US short sellers are set to make around $300 billion in profits in 2022. The S&P 500 fell nearly 20% that year, allowing short sellers to profit from falling stocks. However, short sellers can only sell short those shares that they have borrowed or can reasonably expect to borrow. Where do they borrow from? Brokers typically lend stock to their clients from their own inventory or from the inventory of other clients who have signed up for a borrow and lend program. However, the Securities and Exchange Commission (SEC) in the US does not allow naked short selling – short selling without first borrowing the stock, except in a few limited cases such as market makers.

Is short selling legal in India?

Yes. In India, you can short sell a futures contract for a stock or index. The futures price is simply the price that the market expects the stock to settle on a particular date (expiry date). However, you can increase your futures position by simply rolling over the contract every month. This has a cost – you have to absorb the mark-to-market loss that occurs each time you roll over, and the rollover also incurs a small interest payment. Alternatively, you can buy a ‘put option’, an instrument that limits your drawdown if the stock price rises but allows unlimited profit if the stock falls. However, to buy a put option, you need to pay a premium amount to the seller of the put. There are around 200 stocks which are eligible for F&O trading. Apart from F&O, you can also indulge in short selling ‘intra-day’. This means that you can sell a position during the trading day but you must buy it back before the close of the trading session.

Why are there no big short sellers in India?

India has limited options for short selling. It is difficult to short a stock which is not in the F&O system (Top 200 Stocks). On paper there is a securities lending and borrowing or SLB system. However, industry experts point out that liquidity is poor. “Most of the shorting is through derivatives (futures and options) rather than the SLB mechanism. This is because the SLB mechanism has a high interest rate of 1-1.5% per month and very low liquidity. “SLB also adds additional friction and paperwork,” said Nikhil Kamath, co-founder, Zerodha and True Beacon, an alternative asset manager. But naturally, it prohibits shorting of stocks in F&O,” he said. Kamath further pointed out that India’s regulations do not encourage setting up of large hedge funds that can aggressively short sell. He added , “Institutions like mutual funds cannot short.” Hedge funds exist in India, including Kamath’s True Beacon 1. “However, Category III AIFs have restrictions on net shorting, such as a maximum outstanding position of up to 200% of the fund’s AUM. Kamath said.

Abid Hasan, co-founder and CEO of Sensibull, said retail investors are largely absent from short selling due to lack of awareness and psychological barriers. “Appropriately, they believe that in the long run, markets should appreciate and that shorting can lead to huge losses if trades go opposite to their positions. When buying stocks, they may have to bear the mark-to-market loss in the worst case, but do not face the risk of bearing additional liabilities. This is why retail money is usually invested in long-term strategies,” Hassan said.

Jash Kriplani contributed to this story