How to use short selling as an effective hedging tool

Short selling is all about selling stocks that you do not own. When you have a certain stock in your demat account, then selling the stock and giving a delivery instruction is quite simple. If you own a stock and have a negative view on the stock, then you can exit the stock. Later when the price corrects to lower levels, you can again buy back the stock. But what if you do not own the stock? Can you still sell the stock that you do not own? That is what short selling is all about.

Short selling on an intra-day basis
This is the simplest form of short selling and the least complicated. Since 2001, Indian equity markets have been operating on the system of rolling settlements. That means once you enter into a buy or sell transaction then you can square off the position on the same day. If you have not squared off on the same day then you need to necessarily take delivery on T+2 day. In intra-day short selling, you sell the stock at the beginning of the day betting that the price will come down during the day so that you can cover your position before end of trading. When you sell a stock with the intent to square off the same day, the broker will insist on some margin to be deposited to take care of price risk during the day.

But what if you have a negative view on the stock for a longer period?
Intraday short selling is good in case of a very short term view on the stock. But what happens if you have a negative view on the stock but expect that negative view to play out over the next 2-3 months. Obviously, an intraday short sale will not help you in that case. The answer will be to go for the Stock Lending and Borrowing Mechanism (SLBM). Under the SLBM, if you have a negative view on the stock then you can sell the stock even if you do not have delivery of the stock. Then you can borrow the stock from another investor who has delivery in the stock via the SLBM window and then give delivery. Normally, stock borrowing will be for a fixed period and subject to a maximum period of 12 months. At the end of the period, the stocks have to be returned to the lender and an interest charge is also payable to the stock lender. The stock borrower, who has sold the stock short, intends to make a profit after factoring in the interest cost.

Understanding the key merits of short selling
Contrary to what is popularly believed short selling is a counter approach to value. When you see positive value you buy and when you see negative value you sell. Short selling is as simple as that. The following are some of the key advantages of short selling

Most traders and investors tend to be obsessed with the long side of the market. Short selling enables you to participate on both sides of the market and thus reduces your overall risk of trading in the markets.

Generally, markets which are excessively heavy on long positions tend to become classic case studies for a bigger crash. When there is short selling in the market, the temporary froth in the market goes out and actually makes the market much safer.

One can also use short selling as an indirect form of hedging. Let us say you hold a portfolio of stocks that are not too conducive to short selling due to liquidity issues. You can instead short sell the index in futures or another stock which has a high correlation and that can serve as a proxy for your existing portfolio. Thus overall risk gets reduced.

Short selling opens up an additional source of liquidity and revenue for the traders. There is a short seller who is creating two way liquidity and also providing support to markets in the form of short covering. There is also a holder of stocks who is able to earn revenues by lending stocks to a short seller.

Perhaps Derivatives may offer a better choice
The reason stock lending has not taken off in a big way is that they are currently only permitted on stocks where derivatives is permitted. That actually becomes redundant as those who want to short these stocks already have the choice of doing it either in the futures or the options market. Also, unlike the SLBM, one does not have to do multiple executions first in the cash market and then in the SLBM market. The product can really take off once the SLBM is extended to non-F&O stocks too. That will bring the large number of mid-cap stocks under the ambit of stock lending and ensure that short selling takes off in a big way.

Derivatives have emerged as an effective tool of selling short for a variety of reasons. Firstly, these positions can be leveraged with just a fractional margin being paid. In fact, in case of options it becomes more fractional and also entails lower statutory costs. Secondly, both futures and options are substantially liquid at least in the near month contract. Hence the risk of impact cost is not too much. Lastly, since derivative short positions can be smoothly carried forward to subsequent months at a premium, it has emerged as a more efficient method of carrying forward a short position!