Your Money: Short selling: Stock trading weapon for bears

The margin trading agreement will usually contain a stock loan consent clause.

By Sunil K Parameswaran

As we are well aware, bulls are traders who expect the markets to rise. Consequently, they acquire securities, in anticipation of a situation where they can subsequently sell at a higher price. Technically we say that such traders have taken a long position in securities. Traders who are long, can sell the securities whenever they desire. Their philosophy is ‘buy low and sell high’.

On the other hand, bearish speculators expect the markets to decline subsequently. They aim to profit by borrowing securities, and then selling them. Their anticipation is that they will be able to reacquire the securities subsequently at a lower price and return them. Technically we say that such traders have taken a short position in securities. Traders who are short, have a commitment to buy back and return the securities. This act of buying back and returning the assets is called ‘covering a short position.’ Thus, the philosophy of such traders is ‘sell high and buy low’.

Short selling
In the long run, prices will usually rise due to inflation. Thus, short selling amounts to betting against the overall direction of the market. In the case of long positions, the lowest possible asset price is zero. Consequently, the maximum loss for a trader is his initial investment, which would amount to a 100% loss. However, asset prices have no upper bound. Consequently, a short seller may be compelled to acquire and return the securities at a price that is substantially higher than what was prevailing at the outset. Consequently, short sellers face the spectre of substantial losses if they take a wrong call on the market.

Securities for short sales are usually made available by brokers. Such brokers may have the stocks in their inventory, or else traders who have gone long through them may have given them permission to lend the securities to others. Many traders take long positions by borrowing a portion of the funds from brokers. This is called margin trading. The securities which are acquired have to be left with the brokers as collateral.

Margin trading
The margin trading agreement will usually contain a stock loan consent clause. If the trader accepts this clause, it means that the broker who is holding the securities as collateral can lend them to facilitate a short sale. If a security is priced currently at Rs 100 and a trader shorts 1,000 units, a cash flow of Rs 100,000 will be generated. This has to be left with the broker as collateral. The short-seller acts thinking that the market will fall. However, the broker has to provide for an eventuality where the asset price rises instead of declining. Thus, additional collateral, over and above the proceeds from the short sale, has to be given to the broker.

Short selling is thus a very profitable activity for brokers, who stand to earn substantially in the form of interest. Brokers who lend securities that belong to them, also earn stock lending fees. This may be viewed as the equivalent of interest, for a loan of securities. Institutional investors may be able to persuade the brokers to share some of the interest income with them, by threatening to move their brokerage account to a competitor. This is referred to as a short interest rebate. Retail investors will not have the clout to make such demands.

The writer is CEO, Tarheel Consultancy Services