What are the precautions to take when short selling in equities

Short selling, as we are now familiar, is the sale of shares that you do not own. In the Indian context, you can sell shares short on an intra-day basis. Since Indian equities operate on the rolling settlement system, any long or short position that is not covered on the same day automatically goes into delivery on a T+2 bases. The other option is to sell a stock short and then give delivery by borrowing the stock through the SLBM system. That system is yet to take off in a big way as currently SLBM is only offered on F&O stocks, where the facility to short sell using futures and options is already available.

While short selling may appear to be quite straightforward, there are certain basic precautions to keep in mind

1.  Check out the liquidity and basis risk in the stock
These are two of the most important criteria when you short sell a stock, especially on an intraday basis. Liquidity refers to the availability of substantial number of buyers in the stock. Basis risk is the ability to get the order executed within a tick of 0.05 paisa so that your basis losses are minimised to the extent possible. One can also calculate the impact cost of any stock as that will give a clear idea of how much the price will be impacted by your order. If a stock is illiquid then the basis risk could work against you when you are short selling and also when you are covering your short position.

2.  Be careful when you short sell a stock around key macro events
Key macro events include announcements and policy trajectories with larger implications. Union Budget announcement, credit policy, US Fed outlook are all examples of such macro events. The reason short selling can work against you is that gravity always works stronger on a stock but levitation can take you by surprise when the underlying trend in the market is strong. We have seen the Market react to the Union Budget in Feb 2016 when the market cracked to form a bottom and then pulled up very sharply to leave short sellers stranded.

3.  Be wary of the corporate action risk while short selling
This risk is quite common when you are trying to short the stock around key announcements like mergers, acquisitions, restructuring, demergers etc. In all these cases, the swap ratio or the logic of the corporate action is normally the unknown variable. When you are trying to bet against a stock based on a certain assumption, remember there are umpteen instances when such assumptions have gone wrong. It is very likely that you will be stuck in a position and the market may force you to cover your position at a huge loss.

4.  Never short sell without a stop loss
This follows as a logical corollary to the previous points. Remember, on a majority of the occasions there are more people buying a stock than those selling a stock. This explains why in the Indian context equity indices like the Nifty and Sensex have actually trended upwards over a longer period of time. The answer to this risk is to set your stop loss to protect your risk in case you go wrong. Imagine a situation when you have short sold the stock and the stock has touched the upper circuit on that date. Of course, we are referring to mid-cap stocks because F&O stocks do not have a circuit filter. There have been cases, when stocks have just opened on upper circuit for 3-4 days in succession. Firstly, you will not be able to cover your short position and secondly your short position without delivery will go into auction resulting in huge losses.

5.  Short selling has to be a value / liquidity trade-off
This is the most important thing to remember for a short seller. You cannot short sell purely based on valuation. Even if your analyst concludes with a lot of confidence that Tata Steel at Rs.650 has an intrinsic value of Rs.500, it is not a signal for you to short sell the stock. As we have seen in the last 3 years, liquidity is an important issue. If domestic and global liquidity flows are robust, then even overvalued stocks can go further up and trigger your short positions.

6.  Short selling is all about conviction
The irony of short selling is that when you are short on a stock you actually own nothing other than a belief that the stock will go down. If you have a very high degree of conviction then it is a different ball game. But if your conviction levels are low, then it makes more sense to approach your short strategy through the purchase of put options. At least that will ensure that your downside risk is limited to the extent of the option premium paid.

Short selling is for the more informed and savvy traders. It is a great method of playing a stock on the downside. But as a short seller, keeping some basic precautions in mind will go a long way!