The Hindu Business Line : The long and short of short sales

“We have recently hired Vijay and Rajeev from a business school. Before deploying them in the finance department I thought they should be given an opportunity to partake in the discussions and polish their skill-sets,” said the MD.

Curd Rice looked extremely unhappy. MBAs and consultants were two categories of people he despised. Consultants in his opinion were people who charged astronomical amounts of money only to get all the information required from the employees of the firm and write a fancy report. And what was worse they inevitably found reasons to extend the duration of their engagement. MBAs, in his opinion, were similar. They entered an organisation with superficial knowledge, learnt the ropes from the more experienced employees, and just when they could be expected to make a more meaningful contribution, would inevitably move on elsewhere for a more fancy salary.

Selling without owning

“Okay, as usual I will begin with the last unanswered question from the previous meeting,” said Goatee. “Balaji you wanted to know the meaning of a short sale. Short selling means selling something that you do not own.”

Balaji looked perplexed. “How can you sell something that you do not own?”

“Simple! Borrow the asset from somebody else and sell it.”

“Why would anybody lend you an asset for nothing?” asked Balaji.

“Let me explain,” said Goatee. “Suppose you are holding an asset as an investment. Would you mind parting with it if it is returned to you intact before the end of your planned investment horizon and if you are compensated in the form of a lending fee for the asset?”

“Maybe not,” said Balaji. But what is the assurance that the asset will be returned?”

“In practice what happens is as follows: A broker will arrange for a share to be lent to you either from his inventory or from that of a client. He will have the share sold on your behalf. However you will not get the money. The entire proceeds from the sale plus additional collateral will have to be left with the broker.”

“Why would anybody wish to engage in such strategies?” asked Curd Rice. He was always suspicious of financial strategies that sounded fancy and unnecessarily complicated.

“Let me explain Sir,” said Goatee. “Why do people buy shares? Obviously because they expect the price to rise. If their expectation is realised they can subsequently sell at a higher price and make a profit. We refer to such people as bulls. Now take the case of a person who expects the share to decline in value. A short sale permits him to sell the asset at its current price. If his hunch about the market is realised he can subsequently buy the asset back at a lower price and return it, thereby making a profit.”

Dividend aspect

“What about dividends?” asked Ganguly. “Will I be entitled to receive dividends if they are declared during the period when my shares are on loan to someone?”

“Excellent question! An investor who facilitates a short sale is only lending his shares to the short seller and not selling them. Consequently he has every right to demand any dividends that are declared. What happens in practice is the following: As far as the records are concerned the share has been sold to another trader by the short seller.

“Therefore if the company were to declare a dividend it would go to the person who has bought the share from the short seller. Hence, the short seller has to compensate the lender of the shares from his resources for the dividends which he would have received if he had not parted with the shares. Think of it this way. A short sale leads to the establishment of an actual long position for the investor who buys the share, and a ‘phantom’ long position for the lender of the shares. The buyer of the shares has the normal rights of an investor who has gone long. It is up to the short seller however, to protect the rights of the lender of the shares.”

Stock split

“What happens if there is a stock split?” asked Vijay, the new recruit.

“What is a stock split?” asked Balaji.

“Let me explain with a numerical illustration,” said Goatee. “An 5:1 stock split means that for every shares that you are holding, the company will give you 5 new shares post-split.”

“How does it add value?” asked Curd Rice.

“Theoretically a stock split does not add any value. For instance, a 5:1 stock split in the case of a share with a par value of Rs 10, would mean that after the split the investor would be left holding five shares with a par value of Rs 2 each.”

“Then why go in for a split?’ asked Curd Rice.

“There are theories. One reason could be that if the share price becomes very high then the share goes out of reach for small and medium investors.”

“Going back to short sales, if there is a split before the short position is closed out, the short seller has to return five shares and not one share. Thus the lender is protected.”

Back to options

“Okay, if everyone is ready, let me move on to options. An options contract gives the buyer the right to either buy or sell an asset on or before the expiration date of the contract at a price that is fixed at the outset. As I have already clarified, call options give the buyer the right to buy the underlying asset whereas put options give him the right to sell the underlying asset. I have also explained as to why both parties cannot be given rights. Consequently an option buyer is given a right whereas an option seller, has an obligation imposed on him.”

“What are European and American options?” asked Balaji, trying to appear knowledgeable.

“Every options contract has an expiration date. If the option can be exercise only at expiration, it is known as a European option. However, if an option can be exercised at any point in time till the expiration of the contract then it is referred at as an American option. Consequently the expiration time is the only point in time at which a European option can be exercised and the last point in time at which an American option can be exercised.”

“Are options in India, European or American?” asked Ganguly.

“Stock options are American. However options on the Sensex and the Nifty are European.”

“Well we are coming to the end of today’s meeting,” said the MD. “I am glad that we have finally reached a point for a more meaningful discussion of options. Once again I wish to reiterate that I do not want to dissuade any questions. I am relatively free this week. So I suggest that we meet once again on Friday afternoon.”

Racy@TheHindu.co.in

http://Racycases.blogspot.com

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