Shorting curbs volatility

20th February, 2008

A.Balasubramanian, CIO, Birla Sun Life Mutual Fund
Business Standard
20 February 2008

The recent move of the Securities and Exchange Board of India (Sebi) to allow short-selling of stocks by all market participants after a seven-year ban comes as a welcome move. Unlike ten years ago, when a handful of foreign institutional investors (FIls) and domestic institutions could heavily influence price movement, today we have over 1,000 registered FIIs, several mutual funds and insurance companies along with other traditional domestic institutions. This has allayed past fear of bear cartels causing market distortions and instilled confidence to re-introduce short-selling in the cash segment.

Along with bringing the Indian stock markets at par with advanced markets, Sebi's move ushers in a betterprice-discovery process. This would deepen the markets further by enabling wider participation and add new instruments. It also opens an avenue for long-term investors to participate in lending of shares. From a fundmanagement perspective, this needs to be handled properly in ensuring that it provides additional return onthe portfolio. At the same time, simple shorting the market is as good as taking a call on the valuation of acompany or sentiment in the market or pure hedging. At times, pure short-selling can also backfire, if it is not backed by the strategy of simple hedging, wherein the loss could be unlimited. Therefore, simple short-selling could also depend upon the fund manager's view as they do it while going long on the stock.

Typically, investors resort to short-selling based on current valuation, with an intention to buy back when the stock corrects. Traders also look to arbitrage between the cash and the futures market. For instance, if the spot price of a stock is higher than the futures market, they short the stock and buy in the futures market. This cannot be done at present though the reverse of this, which is a simple arbitrage, is possible, that is, buy in cash and short the futures. The lack of short-selling in the cash market also perhaps explains the immense popularity of stock futures, where short-selling is permitted. This has often led to the cash market taking signals from the futures market.

However, Sebi's move should remove this anomaly by permitting short-sales. The move is expected to make the markets more efficient by presenting proper arbitrage opportunities between the cash and the futures markets. Arbitrage funds that buy stocks in the cash market and sell in the futures market will now be in a position to reverse arbitrage in a bearish market and help true price discovery.

To ease the process, the market regulator will roll out a securities lending and borrowing mechanism (SLB) that will work on an automated, screen-based, order-matching platform to be provided by authorised intermediaries. To begin with, the securities traded in the futures and options segment will be eligible for short-sales.Essentially, short-selling is a tool for traders and arbitrageurs looking for opportunities in prices. Look for short selling, only if you feel the stock has run far ahead of its right valuation.
The rules of shorting
Both retail and institutional inventors allowed to short-sell
Short-sales, without any back up, not permitted
Securities in future and options segment to be eligible for short-selling
A securities lending and borrowing (SLB) scheme to be made operational
SLBs to take place on automated, screen-based, order-matching platform of authorised intermediaries
Institutional investors to be debarred from day trading