Recently there was lot of debate in the stock markets and media about short selling and if it should be banned in view of the volatile global financial turmoil. For those new to stock markets and share market investing here is a brief look at what exactly short selling means and how it affects the stock markets.

Short selling means  the selling of financial assets or securities (stocks, bonds) that do not belong to the person selling it but have been borrowed generally from a broker or a brokerage firm.

Short selling works on the premise of making money over the fall in the price of the asset. The process can be explained using the example of stocks. There are always certain stocks in the market, which are overvalued and overpriced owing to different reasons. A short seller predominantly looks out for such stocks, which are sooner or later, expected to see a fall in their prices.

The short seller then borrows these stocks from a lender and sells them when the prices are still high. The short seller then waits for the prices to dip after which he buys back the same stock and returns it to the lender. The short seller thus makes a profit as he manages to buy the stock back at a rate, which is lesser than what he makes out of the sale of the stock.

Short selling is regulated by the stock market regulators and certain rules of the stock exchange depending on the country.

Most countries have strict regulations on short selling including restrictions regarding the type of assets that can be sold and the time period within which this trading activity needs to be performed. If there are any dividends or rights that come from the stock during the course of the loan, the short seller needs to pay these back to the lender.

You may also need to open a margin account to indulge in short selling. However, you will need to remember that in addition to being profitable, short selling is also very risky. While short sellers use many ratios to predict whether the price of the asset will fall, there is always the chance that prices may see a hike, which can bring considerable losses to the short seller.

Ban on short selling in the US

The Securities and Exchange Commission, which acts as a financial regulator in the US banned short selling of financial stocks on September 19 as they felt that it has contributed towards the fall in stock prices of the banks and could aggravate the financial crisis.

This was as an attempt at boosting the confidence of investors in the securities market. However, the ban came to an end on October 8. Market regulators in countries like the UK and Australia have also introduced bans on short selling.

Short selling in India

Short selling was practiced in India till 2001 but was banned by SEBI, after the Ketan Parekh scam. It was revived early this year. In India, now both retail and institutional investors are allowed to indulge in short selling.

Despite bans in different parts of the world, SEBI has declined the need for a ban on short selling in India.

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