The long and short of short-selling

We need traders with a counter-view as well — who are known as Bears. An investor with a bearish perspective would be of the opinion that the price of an asset is likely to decline. To operationalise his viewpoint he would sell an asset that he does not own. This may sound criminal to a novice,for after all how can a party dispose of an asset that does not belong to him or her. In the stock market,this can be done by borrowing an asset from a broker or a fellow investor and then selling it.

Since the asset is on loan,the borrower has to eventually reacquire the asset and return it to the party who extended the loan to facilitate the initial sale. Such a trading strategy is known as a ‘Short Sale’. When the asset is subsequently bought back and returned,we say that the trader is covering his short position. The philosophy behind such a strategy is obviously to ‘Sell High and Buy Low’ for the expectation of the short-seller is obviously that prices would have declined by the time he covers his position. In principle,a short position can be kept open for a considerable period of time. However,at times the lender of the security may seek to call it back. On such occasions,the short-seller has to either make arrangements to borrow the asset afresh from another source or else cover the position. A bear will short-sell in the anticipation that the price of the asset is going to decline.

But there is every possibility that he may be wrong,and that prices may subsequently increase. Since he is expected to buy back the asset at a price that in principle has no upper bound,the broker who facilitates the short sale will not allow him free use of the sale proceeds. The proceeds will be retained by the broker as collateral. And what is more,the trader will be required to post additional collateral to take care of the possibility of a subsequent price rise. Short-selling amounts to betting against the long-term direction of the market.

In the long-run asset,prices must head north,for if nothing else they ought to compensate the investor for the effect of inflation. Unlike bulls who are confronted with the specter of potentially unlimited profits and finite losses,a short-seller can in principle lose an enormous amount of money because while share prices have a floor due to limited liability,there is no ceiling. From the perspective of the lender of the security,there is a possibility that the asset may generate income during the period that it is on loan. For instance,a company whose shares have been lent may declare a dividend. A short-sale in effect creates two long positions.

When a share is borrowed and sold,the party who buys it effectively creates a long position for himself and will consequently be entitled to the payouts from the asset if any. However the lender of the security will argue that he too has a ‘virtual’ long position,since the intent was to lend the security and not to sell it irrevocably. Consequently,the short-seller has to compensate the lender from his funds,if the asset were to make a payout during the period of the short-sale. Similarly,if the asset were to experience a corporate action such as a stock split or a bonus issue,the borrower of the securities needs to factor in the consequences while covering the position.

However,there is one right that the securities lender loses. If there were to be a shareholders’ meeting during the period the securities are on loan,the borrower cannot bestow the lender with voting rights. Such rights would obviously go to the party who acquired the shares from the short-seller. Short-selling can be a very profitable activity for a brokerage house. Since the sale leads to an inflow of funds,the broker,who as explained will retain the cash as collateral,stands to earn a not insignificant sum in the form of interest. Retail investors will typically not have bargaining power. However,large institutions can often persuade a broker to share some of the interest income with them. If the broker were to agree to do so,it would be termed as a ‘Short Interest Rebate’.

Some economists hold short-sales to be one of the root causes of market downturns,for such activities in a declining market can induce asset prices to get further depressed. However such traders provide a vital market function. While bulls are essential for exploiting under-valued assets,the activities of bears are a sin qua non for enabling over-valued securities to correct in value.

Bulls and bears

* Investors who believe that the price of an asset is going to increase over time are said to have a bullish perspective

* Such investors would acquire the asset and,in market parlance,would be said to have assumed a long position

* An investor with a bearish perspective would be of the opinion that the price of an asset is likely to decline

* To operationalise his view-point,such an investor would sell an asset that he does not own

* This can be done by borrowing an asset from a broker or a fellow investor and,then,selling it

* Since the asset is on loan,the borrower is required to eventually reacquire the asset and return it to the party who extended the loan to facilitate the initial sale. Such a trading strategy is known as a ‘short sale’

* Short-selling amounts to betting against the long-term direction of the market

* A short-seller can,in principle,lose an enormous amount of money,because while share prices have a floor due to limited liability,there is no ceiling

The writer is the author of ‘Fundamentals of Financial Instruments’, published by Wiley India