SHORT SELLING

Latin Manharlal Securities Pvt Ltd

"A New Beginning from 21st April 2008"

Date: 11th April 2008

Short-selling was prevalent till 2001. Sebi banned short-selling after the stock prices crashed in 2001 under the weight of heavy
short-selling by big operators, who exploited the downturn in equity prices during the Ketan Parekh scam. Six years ban on short
selling will now be lifted w.e.f. 21st April 2008 with a small count of 227 F&O stocks. However SEBI has tried to plug the loopholes in
the earlier system this time. This time the regulator have barred from naked short-selling. The traders would be required to
mandatory honor the obligation of delivering the securities at the time of settlement. No institutional investor would be allowed to
indulge in day trading, that is, squaring off their transactions intra-day.

WHAT IS SHORT SELLING?

Recent stock market crash resulted the stock trading to 30-50% discount to its all time high price. Had you ever been absolutely sure
that a stock was going to decline and could make profits from its regrettable demise? Wouldn't it be nice to see your portfolio
increase in value during a bear market? Both scenarios are possible. Many investors make money on a decline in an individual stock
or during a bear market, with the help of investing technique called short selling.
Short-selling refers to the practice of selling a stock which the seller does not own at the time of trade with the hope of buying it back
at a lower price. At present, individual traders' short-sell shares during the day and square off their positions before the closing bell.
However, institutions are not allowed to indulge in such intra-day speculations. Now, SEBI is putting in place a mechanism where the
short-seller can borrow the shares to meet the delivery commitment. Just as an investor borrows money to buy shares, it will now be
possible to borrow shares to sell. If the price drops, you can buy back the stock at the lower price and make a profit on the difference.
If the price of the stock rises, you have to buy it back at the higher price, and you lose money. Under this, all categories of investors
can now lend the stocks they own and borrow the ones they don't.

MECHANISM OF SHORT SELLING

Traditionally World over, securities lending and borrowing transactions were, by and large, over-the-counter (OTC) contractual
obligations executed between lenders and borrowers. Latter in many international markets, entities like custodians and depositories
run the lending and borrowing scheme and have their own screens for meeting the demand and supply of securities from their
clients.

SEBI however, intends to introduce a vibrant stock lending and borrowing (SLB) programme along with short-selling. This means
traders are required to borrow shares they sell short from the SLB scheme to honour their trades. All classes of investors (including
retail), who own shares, can participate in the SLB scheme and earn a fee for lending their shares to short-sellers. Institutional
investors are also required to disclose upfront at the time of placement of order whether the transaction is a short-sale and
demonstrate their ability to borrow to the satisfaction of the broker. Retail investors, however, would be permitted to make a similar
disclosure before the end of trading hours on the transaction day.

The Short Selling mechanism will be carried out with the help of an automated, screen-based and order-matching system similar to
current trading terminals, which will be provided by the clearing houses of stock exchanges. To begin with, all stocks in the futures
and option segments will be eligible for borrowing and lending. The tenure of borrowing/lending shall be fixed at 8 days. According
to a brokerage, investors may have to first borrow them to short-sell and for this; exchanges may allow a one-hour window in the
morning. This will allow players to borrow in the morning and sell during the day.

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Research Desk
Special Report - Short Selling
STOCK BORROWING & LENDING MECHANISM (SBL)

Investors lend the stock

which they are long on with INVESTORS/
a view of earning additional MF's/HNI's
return on their ideal stock.
(Have a Long Term
(STOCK LENDING
View on the stock)
MECHANISM).

k
oc
st
Arbitrageur will

LB

ed
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borrow this stock by

ow
(1
paying a margin for

rr
bo
the purpose of going

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th
short on the stock ck
Ba
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et
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(2) Sells when stock is overvalued

ARBITRAGEUR
(Does Not Hold the CASH MARKET
(3) Buys back when stock is fairly valued
Stock but has a Desire
to Sell the Stock)

MERITS OF SHORT SELLING

1. Facilitates Price Discovery

In the current market scenario the stock price majorly differs from its actual intrinsic value resulting in stock either being
undervalued or overvalued. Short Selling facilitates the price discovery of such stocks by allowing people with
heterogeneous opinions to be factored into prices & correcting the valuation of the stock.

2. Balance Between Pessimistic & Optimistic Investors

Institutional investors, forbidden from going short in the cash market, were also not allowed to take naked short positions
(Sell shares they actually dint own) in the future markets, in a bid to curb speculation. That meant that the pessimistic
investors had little choice but to sit and wait it out on the sidelines while optimistic investors charged into the market a clear
imbalance. Short Selling will help to balance equation between the two by boosting the volumes & deepening the markets.

3. Strengthen the Sell Side

Only retailers were allowed to sell in the cash market, but in the absence of a formal mechanism to borrow shares they had
close their positions within the trading day. Introduction of Short selling will help in structuring the SLB mechanism &
widening the trading cycle to 8days, thereby strengthening the sell side.

4. Reduces Volatility
Short Selling increases liquidity in the market & also reduces the bid-ask spread there by reducing the volatility.

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 Research Desk
Special Report - Short Selling

5. Increases volumes in the market

Short selling enables to pump in idle stocks in the market which helps in increasing liquidity, thereby increasing the dept of
the market. The current average volume per stock on the CNX 500 is about 0.27% of the total equity. The same figure for
S&P 500 in US stands at 0.65 %. Even in Malaysia introduction of more indices & trading contracts for the purpose of Short
Selling increased it's volumes 3 times. Hong Kong also had a similar experience.

6. Provide clear indication of sentiments of the markets

The total number of shares that have been sold short in a security. This is an indicator of the bearishness in a particular stock.
Thereby indicating market sentiments.

7. Enable the Mutual Fund & HNI's to earn 5-7% higher returns
The biggest gainer from the short selling will be mutual funds. Mutual Fund & HNI's will see at least 5-6% higher returns as
they will be able to lend out stocks which, until now have remained idle while maintaining long term view & benefiting from
the dividend yields. They can let their portfolio earn income while still possessing the stock.

8. Facilitates Reverse Arbitrage

ARBITRAGE REVERSE ARBITRAGE

RIL Cash Rs.2500 RIL Cash Rs.2550

RIL Future Rs.2550 RIL Future Rs.2500
Premium Rs.50 Discount Rs.50

Sell in F&O and Buy in Cash to earn a difference of Rs.50. After introduction of short selling one will be able to go
Till date one could go short on a stock only if the future is short even if the future is trading at discount by Selling in
trading at a premium and not otherwise. Cash & Buying in F&O to earn a difference of Rs.50.

9. Short Selling will not attract STT (Security Transaction Tax)

RISK INVOLVED
1. Losses are Infinite, where as Profits are Limited

2. Short Squeezes
If a stock starts to rise and a large number of short sellers try to cover their positions at the same time, it can quickly drive up
the price even further. EG. Essar Oil's open interest crossed Market-Wide Position Limit (MWPL), there after the trading was
consequently banned. The stock future was trading at Rs.64 when the company announced preferential allotment to
promoters at Rs.200 a share. Essar stock jumped to Rs.204 making it impossible for the short players to save their shorts by
closing their positions.

3. Bear Raids
The fear of deluge of selling that will irrationally drive down the stock prices. By taking on large short positions or spreading
rumors, traders can send stocks into tailspin for their own advantage.

4. Being too Early

Largest complication is being right too soon. Even though a company is overvalued, it could conceivably take a while to
come back down. In the meantime, you are vulnerable to interest, margin calls, and being called away.

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Research Desk
Special Report - Short Selling

5. Increase in Volatility in a Bear Market

Its is believed that Short Selling increase share price volatility, and force the price of individual stocks down to levels that
might not otherwise be reached. In a bear market in particular, short-selling can contribute to disorderly trading, give rise to
heightened short-term price volatility and could be used in manipulative trading strategies.
6. The sentiments of the markets will be decided by the disclosure of Short Interest Data which may either be fortnightly or
weekly similar to that of in US.

CONCLUSION
Introduction of Short Selling has lead to efficient price discovery, as reflected in a variety of measures such as liquidity & bid-ask
spread. It also helps in providing higher volumes & good depth in the market. However sentiments related to Short Selling in the
markets will broadly depend on the data given in the appendix which would be either provided fortnightly or weekly. Fortnightly
disclosures will however not make any sense for India since all short positions have to be closed within 8 days. In US various data
are provided on fortnightly basis where as in the case of India the proper impact of the short selling would depend a lot on the
number of data and the frequency at which they would be provided.

APPENDIX
Short Interest: Short interest is the total number of share that has been sold short in a security. This is an indicator of the
bearishness in a particular stock.
Short Interest Ratio: The short interest ratio is calculated by dividing short interest by the average traded volume in the stock.
It is also an indicator of market sentiments and also gives an approximate idea of how many days it will take to cover all shorts in
the market if prices begin to rise.
Short Interest / Float: This ratio tells about how close the short interest is to utilizing the entire float. The closer it gets, the
greater the volatility in stock price.

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