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Can Banning Short-Selling Help the Markets?

21 Mar 2020

Just like an upward going market helps people make money, a downward trending market too gives a lot of opportunities to traders to earn money. But doing that further makes the market go down instead of helping the market recover its losses and it is the reason why the market regulator – Securities and Exchange Board of India (SEBI) is considering to restrict short selling for a short time to cope with the sudden slowdown brought about by the spread of Coronavirus disease.

What is Short selling?

As a trader, you must have heard of the term short selling and there are chances that at some point of your trading career you have also used it as a strategy to gain profit from the market. Short selling is the process of selling a stock first with the hope of buying it later at a lower price.

Though it looks very straight forward but it isn’t. In a bearish market, many traders sell out a stock first at a higher price. When the price falls further they buy it at a lower price which helps them to earn profit. It looks impossible that how can someone sell a stock without having the possession of it, but it is possible because the settlement of all trades is done in T+2 days. Though this technique is not ethical but is not illegal either.

Why this ban now?

Currently, the market is already in bearish phase. The Nifty 50 has hit the lower circuit. Those defending short selling believe that Short selling interferes with the natural price discovery and also reduces the liquidity up to a great extent.

In this crisis, when almost all the market indices are in red, the Chinese market is amongst the very few markets which is showing positive momentum. The main reason being the regulatory authorities recognized the need and immediately banned short selling as soon as the market started to move bearish. The ban probably reduced the speculative hammering of stocks and thus proved helpful in stabilizing the markets.

The main issue with short selling is that it promotes market crash. Naked Short Selling which means that selling any security without owning it. Such sales have the power to set off a cycle where falling prices trigger market panic and force people to sell their holdings, which in turn pushes the price down.

What the regulator can do?

The regulator just needs to ensure that every sell trade should be backed up delivery of shares. This means that any seller cannot square off his sell position during the day and must deliver shares. It is not a tedious task for the regulator to ban short sell in the equity market. However, it will be tough to ban short selling in the future segment.

Investors too should avoid short selling to bring the market back on track. Instead of creating selling n the market, it is better to stay in fundamentally sound stocks. After the Covid-19 outbreak, stocks from segments such as hospitality, aviation, cinema etc. are affected but there are various sectors which are showing positive momentum. It is better to look for strong fundamentals and sound balance sheets before taking any investment decision.

Short selling can be profitable in short term but the adverse effect it has on the market movements is going to last for long. It is necessary for the SEBI to take action against this to bring the market back to track. Investors too should realize this reality and opt for other strategies to extract profits from the market.

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