Investors tend to flock to bull markets - where the price of nearly all stocks tends to go up. This only works when prices go up, but as we have noted time and again, stocks don't always go up. Sometimes the overall market turns in its track and all stocks head downwards - and some other times, certain stocks show signs of weakness and slip downwards.

Most of us, as investors, have placed our bets on stocks going up. We like the management, or the sector, or the company, and buy the stock. In a few years, if we are correct, our stock will be at a higher price, giving us a profit when we decide to sell. We research companies based on their annual results, their conference calls and newspaper reports and choose the right stocks to buy.

This is the story you hear all the time. Buy and hold for the long term, they say. Buy and forget about a stock. But what if there is something wrong with the company you have bought? Is your only alternative to sell the stock you own? Is there a way to profit from a gross overpricing of a company's shares, if your analysis shows there is no further upside to the price?

Very recently, a series of revelations on "derivative transaction losses" rocked a number of Indian banking stocks. These stocks fell a good 20% on the news. Not quite in a day or two, but in a matter of three weeks. In January, the entire stock market collapsed and fell over 30% in a few days. Yes, most of us now realize how grossly overpriced certain stocks were, but was there a way to invest in the reverse direction - profiting when prices went down?

Enter short selling.               

It's easy to understand the "buy low and sell high" concept. You buy, you hold and you sell. What if you could "sell high" first, and then buy low later? Short selling allows you to do that. Short selling is essentially selling stocks that you have not bought. (Selling them short) You borrow shares from someone who owns them, and sell them in the open market. As the price drops, you can decide to buy the shares back and return them to the owner.

Two questions arise: Why would someone loan their shares? Because the borrower will pay them interest on the amount borrowed. This makes sense for those that buy shares for the really long term, who make little money on the shares for years until they decide to sell. And mutual funds, which tend to hold large blocks of shares and don't sell on regular price fluctuations, can now generate income from their holdings without selling.

And what if the lender wants the shares back? There is an obligation to return the shares if requested, and the borrower is also required to pay any dividends paid out in the meantime. The returning, however, is not immediate - and can take two days in the Indian context where the settlement cycle makes it that way.

There are Risks to short selling: Firstly, you are speculating that price goes down. If it goes up, you will end up losing money. In a "long" transaction - where you buy first and sell later - you can lose a maximum of 100% of your money. In a short transaction you can go much more than 100%. Consider a person who shorted a share which cost him Rs. 100 time, and which later rose to Rs. 300. For every share, the borrower lost Rs. 200 - two times the original outlay.

Now how is this applicable to us in India? There is a long history of this for those of you who are interested. Short selling used to be allowed "naked" - i.e. you could sell without owning the underlying shares, with the assumption that you would buy back before the delivery date - under the badla system. Settlement periods were upwards of one week, so if you short-sold shares today you could buy them back within a week and "square off" the transaction, without shares changing hands. (This led to an interesting tussle between Dhirubhai Ambani and some brokers [1])

The badla system is no longer available, and settlement periods are now one day. So you as a retail shareholder have some different choices. Let's go through each of them.

Intraday "Naked" short ‘selling:

Individuals are allowed to sell shares short, without borrowing them, as long as the transaction is "squared off" by the end of the day, by buying the same quantity of shares back. This it may not be of interest to those of you that aren't intraday traders. After all, the reasons a stock needs to be shorted may not work out in a single day.

Futures and Options

I will not delve into details of these products, but suffice it to say that instead of delivery in one day, these products allow you to carry a trade for a longer time - one, two or three month "contracts" are available as futures and options on around 220 stocks.

Future contracts allow you to be "long" i.e. pay money to buy shares at a price now and settle the transaction one, two or three months later (at whatever price the stock is then).

They also allow you to be "short" - so you sell at the current price, and buy back later.

Options involve a much longer discussion and isn't very relevant to the topic at hand, but more information is provided in a footnote.[2]

Futures and options contracts are typically 2 lakhs or more in size per contract. It's not for the faint hearted, and the leverage involved can drive people to take much larger risks than they should. Still, with application of discipline and learning, one can use the futures and options markets to benefit from price changes in both directions; up or down.

I would personally not recommend a futures and options trade unless one understands the potential risks involved, and definitely not for anyone with a portfolio under Rs. 5 lakhs. Tread with care if you should consider this route.

Stock lending and borrowing

Recently, SEBI has allowed short selling again, but only to institutions. A new product, the Stock Lending and Borrowing System (SLBS) has become operational where any institution can borrow shares to short sell.

Retail individuals cannot borrow, but they can lend their shares. Between 10 and 11 AM, an auction is conducted at the stock exchanges where anyone can put their shares up for borrowing. The shares are borrowed for a week, at a price agreeable to both - the lender puts up shares at a price (the "asking price ") and institutions bid for shares. Where the prices match a transaction is recorded and the lenders shares go to the borrower's account, for one week. After the week, the shares change hands back, and the borrower must go borrow again through the SLBS window.

It's a new system and not every broker allows their clients to access it. But that is changing rapidly and in a few months, most of us will be able to lend our shares to be used for short selling.

Note here that you can't yet be a borrower, but hopefully SEBI will let everyone borrow as well. That is the stated intention, and it's only a matter of time.

The idea of lending shares for short selling may trigger your thoughts about tax. If I lend shares, does it become a sale because shares are transferred, and so must I pay tax on the gain? The Income tax department has come out with a circular stating that lending shares for short selling does not amount to a sales, so no capital gains tax applies. Of course any income you make on the transaction - the "fee" you receive for lending shares - is subject to tax. (But then, something is better than nothing, especially on large, long term portfolios)

In a nutshell

Short selling can help you, as an investor, profit from falling prices. It can also help you as a long term holder of shares, to generate some income while you own the shares - by lending them to a short seller.

Short selling and stock lending is common in most developed markets. It's new to us in India, and it will be interesting to see how popular it gets. Over time, it will become an intrinsic part of our markets as well.

[1] Some brokers had shorted a large quantity of Reliance shares in 1984, to push the share price down. They assumed they could buy later at the lower price, and make a killing, at the retail shareholders' expense. But they had not accounted for the now-famous Ambani grit. Ambani, with the help of a few other people, bought all that the brokers sold, and demanded delivery of shares at settlement. The brokers had to buy a massive quantity of shares at higher prices - the Ambani buying had taken the share price up instead of down - and they lost a large amount of money. The stock exchange was closed for two days during this and Ambani emerged as a messiah of small shareholders, having stood up to the people who had, till then, routinely ruined the fortunes of the mass public.

[2] Option contracts can be long or short, and as a buyer, you can benefit if the stock goes below a certain price (while limiting your payout if the stock stays above a certain price). You can buy a "put" option which gives you the right (but not the obligation) to sell a share at a certain price. For instance in January you could have bought a one month "put" option on ICICI Bank, to sell it at Rs. 1280. Someone selling you this option has the obligation to sell at Rs. 1280 within the contract period (one month).

Why would someone sell you this option? It doesn't come free - you pay a "premium" for this option. Let us say this was Rs. 50 per share. The premium stays with the seller - so you as a buyer will only profit if the share comes down below Rs. 1280 minus Rs. 50, or Rs. 1230 per share. ICICI bank shares had fallen to Rs. 1100 in that time so a put option buyer would have made a profit.

Note however, that it has been noted statistically that most options remain unprofitable, and the "premium" usually remains high for stocks that have a lot of negative news. So most option buyers are not able to profit because either the stock doesn't fall quite as much to cover the premium paid, or the stock doesn't fall within the time period of the contract.

Deepak is co-founder and CEO at Moneyoga.com, a stock market analytics portal for the Indian markets. Deepak is currently working on algorithmic trading and automated trading systems research. In his spare time, he likes to trek, write and drink different types of coffee.

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