Short Selling

Short selling is the sale of a security that the seller does not own at the time of sale, with the expectation that its price will fall. The seller arranges delivery by borrowing the security, later buys an equivalent security in the market, and returns it to the lender. It creates a short position, whose value increases when the security's price declines.

How a short sale works

The short seller first sells borrowed securities at the prevailing market price and subsequently closes the position by purchasing equivalent securities.

• If the repurchase price is lower, the seller earns the price difference after deducting borrowing charges, transaction costs and other fees.
• If the price rises, the seller incurs a loss because the securities must still be bought and returned.
• Potential profit is limited by the price falling towards zero, while potential loss is theoretically unlimited because the price can keep rising.

Covered and naked short selling

In covered short selling, the seller borrows or arranges to borrow the security so that delivery can be completed on settlement. In naked short selling, the seller sells without having borrowed or arranged the securities required for delivery.

• A securities lending and borrowing mechanism enables temporary transfer of securities against agreed fees and collateral.
• Failure to obtain securities can create settlement risk and result in an auction or other exchange-prescribed consequences.

Market role and regulation in India

Short selling may improve liquidity and price discovery by allowing adverse information and bearish expectations to be reflected in prices. It can also support hedging, but concentrated short selling may intensify downward price movements and therefore requires safeguards.

• Under the SEBI framework, retail and institutional investors are permitted to short sell subject to prescribed conditions.
• Naked short selling is prohibited in the Indian securities market, and investors must meet their delivery obligations at settlement.
• SEBI requires disclosure of short-sale transactions through the prescribed exchange mechanism and facilitates settlement through securities lending and borrowing.

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