Your Money: Short selling: Stock trading weapon for bears


The margin trading contract usually includes a stock loan approval clause.

By Sunil K Parameswaran

As we know, bulls are traders who expect the markets to rise. As a result, they purchase securities in anticipation of a situation where they can later sell at a higher price. Technically, we say that such traders have been long in stocks. Long traders can sell the stocks whenever they want. Their philosophy is "buy cheap and sell high".

Bearish speculators, on the other hand, expect the markets to decline later. They want to take advantage of it by borrowing securities and then selling them. They assume that they can then get the securities back at a lower price and return them. Technically, we say that such traders were short in securities. Traders who take short positions have an obligation to buy back and redeem the securities. This act of buying back and returning the assets is known as "covering a short position". Hence, the philosophy of such traders is "sell high and buy low".

Short sales
In the long run, prices will usually rise due to inflation. So short selling is betting against the general direction of the market. For long positions, the lowest possible asset price is zero. Hence, the maximum loss for a trader is their initial investment, which would mean a 100% loss. However, asset prices have no upper limit. As a result, a short seller may be forced to buy and return the securities at a price that is significantly higher than it was initially. As a result, short sellers face significant losses if they take a wrong call in the market.

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

Margin trading
The margin trading contract usually includes a stock loan approval clause. If the trader accepts this clause, it means that the broker holding the securities as collateral can lend them to facilitate a short sale. If a security currently has a price of Rs 100 and a trader shorts 1,000 units, a cash flow of Rs 100,000 is generated. This must be left with the broker as security. The short seller expects the market to fall. However, the broker must provide a way in which the asset price goes up rather than down. Therefore, the broker must be given additional collateral in addition to the proceeds from the short sale.

Short selling is therefore a very profitable activity for brokers who can make substantial profits in the form of interest. Brokers who lend securities they own also earn fees for lending stocks. This can be viewed as the interest rate equivalent for a securities loan. Institutional investors may be able to convince the brokers to share some of the interest income with them by threatening to move their brokerage account to a competitor. This is known as the short rate discount. Retail investors will not have the power to make such demands.

The author is the CEO of Tarheel Consultancy Services

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