Here is what one is most likely to find in a bear trader's manual on how to profit from short selling.
• Go after companies with weak or worsening fundamentals.
• Look for problems in the balance sheet (too much debt, for one).
• Target promoters who are over-leveraged (having pledged a big chunk of their shares).
• More specifically, aim for promoters who love punting in their own stock.
• Stocks with a combination of weak fundamentals, eligible for futures & options trading, and a market-cap crazy promoter, are ripe for short selling.
• If possible, find out from the market or from a source at the financier (where the promoter has pledged shares) the trigger point for margin calls.
• If the stakes are high, it even pays to have a mole in the target company who can pass on vital information about the promoter’s counterattack plan.
• Check the general sentiment in the market. Short sales have the maximum impact when the overall outlook (both on the economy and the market) is bearish.
• If all these conditions are satisfied, just go ahead and start hammering the futures indiscriminately.
And that is exactly what bear traders seem to be doing when shorting!
Companies where stock prices have plunged dramatically (prompting howls of protest from the promoters) satisfy many or even all of the above mentioned conditions.
And whatever the promoters’ claims, bears cannot hope to profit unless the company’s fundamentals are weak the overall market trend, bearish.
Here is how massive short selling of futures triggers a slide in the stock price. Stock futures always trade at a slight premium to spot price, and this gap is usually constant, except in very volatile market conditions.
Many traders make a small but low risk profit by short selling stock futures and simultaneously buying an equivalent quantity of shares, in what is known as cash-futures arbitrage.
Assume the stock future is quoting at Rs 101 and the stock at Rs 100. The trader will sell the future, buy the share, and lock the one-rupee profit. On expiry day of the contract, the trader will reverse the transaction i.e, he will buy the future and sell the share. As long as the gap between the futures and the spot price is same (irrespective of the prices at the time of expiry), the trader is ensured of his profit of one rupee. That is because any profit/loss on one leg of the trade will be offset by the loss/profit on the other leg.
What bear traders try and do is to short sell the futures so much that the futures start quoting at a discount to spot price, instead of the other way round. This then triggers a reverse arbitrage trade, as players try to cash in on this differential. Assume now the stock is available for Rs 100, and the stock future for Rs 99.
Those owning the shares will sell them, and buy an equivalent quantity of futures, thus locking in the profit. As the supply of shares in the market increases, the stock price starts to slip. And as the gap between futures and spot is usually constant, the futures price will also start to slip, benefitting traders who have short sold the futures.
If the promoter has pledged a sizable chunk of his shares, the weakness in stock price will trigger margin calls, wherein he has to either deposit more shares as collateral or return a part of the money he has borrowed. If the promoter is unable to meet the margin call, the lender will dump his shares, causing the stock price to crash.
There have been a few instances when bear cartels have actually have maximized their profits by timing their sell trades to perfection. In 2009, bears increased their short positions in the stock of a non-conventional energy major after getting to learn that the promoter had stepped on to a flight to Europe to mobilize funds.
The stock fell below a trigger price, prompting many lenders to dump it and caused a complete rout. The bears would not have been so aggressive if the promoter was around, because they knew he could somehow support the stock price temporarily. But his travel plan was leaked to the bears, who then made a nice meal of the stock.