Shorting and Indian capital markets

https://zerodha.com/z-connect/trending/shorting-and-indian-capital-markets

by chedine • 5 years ago

225 122 5 years ago

Zerodha (top Indian broker) posted an article earlier which explained why the Indian brokerage industry has very few avenues to make revenue: https://zerodha.com/z-connect/rainmatter/the-race-to-zero-ca...

The lack of any mechanism for payment for order flow is quite interesting - how do market makers get incentivized to provide liquidity in such situations? Or asked another way, are American market makers being subsidized by retail traders?

kgwgk2• 5 years ago

how do market makers get incentivized to provide liquidity in such situations?

Buy low, sell high.

PS: By the way, I'm not sure I understand the question. Market makers are the ones who pay for the order flow.

smabie• 5 years ago

maker rebates also are a pretty significant incentive

seanhunter3• 5 years ago

Market makers are incentivized to provide liquidity by the fact that they earn half the spread on average every time they trade. If a stock trades for 10 bid 11 offer then the market maker makes 1 every time they buy at 10 and sell at 11. They do this a very large number of times a day.

I'm not sure this still happens, but Marketmakers (and broker dealers) also used to earn rebates from new venues to incentivise them to trade on MTFs (multilateral trading facilities or alternative execution venues).

You'll hear a lot of people talking about market makers (eg Citadel) paying for flow. The common opinion is that this is because that flow contains information that the marketmaker can profit from. This is almost never the case, and in fact if the flow has alpha (positive or negative) or is overly directional that's not great for the marketmaker as they are forced to temporarily take the other side of that trade and try to find unwinds. Marketmakers want more flow because that makes it easier for them to do their job of hedging their inventory and unwinding positions with minimal impact. They are betting on the underlying math that if the flow gets large enough it becomes zero alpha by definition and they can just earn the spread.

twic2• 5 years ago

To expand on this a little for anyone interested, the problem with classical market-making is that you only make money as long as the trades are crossing back and forth around a stationary price. If the market moves suddenly, you end up losing money. In your example, if a huge sell comes in at 10, and the market then moves down to 8 bid, 9 offered, the market maker has a position they bought at 10, but can only sell at 9 at best.

So, profitability depends on the ratio of the nice "random crossing" to the nasty "toxic flow". The toxic flow tends to come from large, well-informed market participants who can act very quickly. That means institutional players with colocated trading machines and so on. There are none of those on retail brokerages, so retail flow has a great ratio of random crossing to toxic flow, and so market makers are happy to pay for it. Meanwhile, the exchange itself is crowded with players like that, and there's a worse ratio, so market makers are a lot more wary.

This is why market makers invest a lot in low-latency trading. If you can find out about an impending market move, and cancel your resting orders before other participants cross into you, you can dodge the toxic flow, and have a better chance of making money.

Longer explanation: https://insights.deribit.com/market-research/toxic-flow-its-...

Unrelatedly, another source of revenue for market makers is maker-taker pricing, where the person crossing the market pays a little fee to the person who rested the order they crossed into:

https://www.investopedia.com/articles/active-trading/042414/...

But i'm not sure how common this is these days.

bhaavan• 5 years ago

A lot of movement in GME was driven by call options, which is generally available in all markets. However, absence of overnight short positions would definitely diminish the trigger GME needed to get short squeezed and become volatile in the first place.

RobertoG• 5 years ago

>"In some of these stocks, the total quantity of stocks shorted (stocks borrowed and sold + using derivatives) is much more than the free float or the total number of shares held publicly. "

So, they short more stocks that exist. OK, I will not ask why this is allowed, but how is this done?

mmmateo• 5 years ago

When you lend someone a stock you borrowed, it’s considered an additional ‘stock shorted’

nico_h• 5 years ago

And the entity that bought it from the short seller can lend it to someone else, leading to two short shares, etc...

Also, there is a difference between 100% of the stock and 100% of the float. Because in theory the institutions holding could alter their positions or lend their shares as well.

hutzlibu• 5 years ago

How is it called, when the person you lend your stock to, lend it to someone else, who lends it again to you and you lend it to the first person again?

Madness?

(Anyway, my actual knowledge of the stock market is limited, but is my scenario a realistic one?)

thargor3• 5 years ago

No. Shorting is selling a stock you borrowed. Multiple borrows does not make a short.

kumarvvr• 5 years ago

Its like you leasing your house. Your assets still show the house. The lease holders address is the house. If you just see the records, there are two houses. But if you actually count, thereis 1 physical house.

teruakohatu• 5 years ago

It's more like you lease a house from the owner and then lease it out again. There are two leases, but only one house. The house has been leased 200%.

thargor3• 5 years ago

No it's like you leasing your house. Selling the house to a third party. One party (your buyer) owns the house. The original owner also owns the same house, since he only leased it to you.

But houses are non- distinguishable. You don't need to give him back exactly that house, just an identical one.

TeMPOraL5• 5 years ago

Stock [purchased by] A [lends to] B [shorts to] C [lends to] D [shorts to] E ...

There's one stock, but when people count shorts, they're counting the [shorts to] edges. That 140% ratio is essentially the (amount of [shorts to] edges) / (amount of stock in circulation).

newswasboring2• 5 years ago

This has been explained to me several times since last week. What nobody mentions is why is it done this way? It just feels unnecessarily obscure. What am I missing?

acd10j• 5 years ago

But Person A etc after lending no longer own stock, as they have lended it. They no longer have possesion of stock, If they now wants to sell their stock they first would need to get it it back from Person B, Which needs it back from Person C etc. Only one person can actually sell stock which is person E, as he has possession of stock. So if there is actual demand of selling a stock a high enough price, So in case person A wants his stock back he will either demand premature cancellation of his lending/leasing of stock, or wait for his lending period to end.

seanhunter3• 5 years ago

You open a margin account and post some collateral (usually cash or treasuries). You sign a margin agreement (which is essentially a credit aggreement) committing to pay up for any losses. The broker can use the posted collateral to cover losses and you will be asked to put up more margin if losses deepen beyond a certain point.

There are a few different ways to be short of a stock but the most common are to sell short in which case you have a few days to buy the stock or locate a borrow before the trade settles. Other ways to be short are to write call options which you can just do by selling that option to someone, or buy put options. In certain cases you can short a contract for difference or single stock future or short the return on the stock in an equity swap. For all of these you'll need your broker to facilitate.

Brokers don't work together which is how the aggregate position of all shorts can get larger than the total number of stocks in issue. This is obviously not a healthy situation but the brokers are relying on the collateral to enable them to make good any losses.

Finally some people may have a short as a partial hedge for an overall long position (eg "Crash put protection") so may be net long overall.

seanhunter3• 5 years ago

It's worth adding that in some of the examples I gave above you can be short a stock but settle as cash so you don't necessarily need to locate physical stock to pay up.

In those examples the price of the stock is just a reference point used to calculate the quantity of the cash payment between the two parties so although the short will lose money if the stock rises they are not "squeezed" in the sense they are not desperately searching for stock to buy at any price.

ignoramous• 5 years ago

While everyone is celebrating retail traders winning over a large hedge fund in this case, it rarely ever plays out this way. Most commonly, retail ends up losing money when there is excessive speculation.

This is the only passage anyone with too much at stake (than they can afford) in this short needs to read.

Other than that, I believe industry insiders / traders are missing the mark in that the current dynamic is also fueled in part by a million-strong (if not more?) rejecting the fundamentals and pumping cash in to businesses that Wall Street's hive mind has decided has no job being in existence.

AMC made a billion dollars during the rally [0] (and it is not lost on me that this capital would be dumped into parachute payments and bonuses to c-suite and nothing's going to trickle-down). In the off-chance AMC makes the capital work, then, that'd have vindicated retail, but it kind of seems too optimistic but that's the whole point.

[0] https://movieweb.com/amc-theatres-raises-one-billion-dollars...

WJW3• 5 years ago

Eventually, either the Wall Street "hive mind" (really though, WS contains thousands of funds and many would be overjoyed to see some competitors fall) or the retail buyers of these companies will be proven wrong. What happens next is way more interesting than the current situation.

Even if it turns out that GME can be short squeezed until there is not a single share shorted anymore, the retail investors will then collectively be HODLing a ton of stock in a company losing hundreds of millions per year. Buying pressure for such stocks is typically low. There is no way everyone can get out at the top, so a lot of people will have to sell at very low prices. This is even true if the original thesis of "we can pump this stock to $1000" is true.

PeterisP• 5 years ago

"There is no way everyone can get out at the top" - this is the big issue here - as far as I understand, the position of WallStreetBets is that there are (were?) so many shorts of GME compared to the shares on market that they would be required to buy all that stock and everyone can get out at the top. I don't feel certain about this (especially since if any of the funds actually go bankrupt, they would default on their obligations, not actually buy the shorted stock at all and just owe some not-fully-collectable money), but that seems to be the whole reason for this situation.

ZephyrBlu6• 5 years ago

There is no way everyone can get out at the top, so a lot of people will have to sell at very low prices. This is even true if the original thesis of "we can pump this stock to $1000" is true

This is what I've been thinking about the whole time. They can definitely pump the stock if they keep HODLing, since sellers effectively set the price when the short positions have to be closed.

Someone still has to be the bagholder and end up holding near worthless stock at the end of this though.

$GME will come crashing down once the short squeeze is over, and there's only going to be a small minority of retail traders who get out at the top.

People who have bought in later at hundreds of dollars are likely to lose a lot of money IMO. Possibly to the tune of over half their initial investment.

lovich5• 5 years ago

rejecting the fundamentals

I think what is missing in many people's analysis is that there is a new fundamental value in this situation. Buying GME shares is now linked to destroying a hedge fund and ruining some billionaire's days. For many people, and I include myself in this group, that has a real tangible value that outweighs the actual dollar amount it costs to buy a few GME shares.

When the leaders of these brokerages and hedge funds ponder as to why people are throwing money at something that is likely to crash and burn when it will likely not make money and is just hurting the billionaires, they are staring the answer in the face

WJW3• 5 years ago

While some billionaires are having a terrible week, market makers and prop trading desks have been making an absolute fortune. I'm sure the billionaires owning the market makers are more than happy to sell "financial uprising points" to WSB readers if they so desperately wish to purchase them.

It's a mistake to see "the billionaires" or "Wall Street" as a single homogenous group. 99% of them don't mind Melvin capital going under at all.

xadhominemx4• 5 years ago

Buying GME is in fact not linked to destroying a hedge fund as the funds with large concentrated short positions exited the investment several days ago. The situation now is a bonanza for billionaires, as many have gone long the stock or are providing highly lucrative retail options market making services. The entire narrative about gme now being some sort of populist uprising is a sham perpetuated by those who want to bring fresh bag holders into the name.

batmenace• 5 years ago

Destroying a hedge fund is also not a 'fundamental value', no matter how satisfying it might sound. Also, as I've said before, often the largest investors in hedge funds are pension funds or similar pooled vehicles, so screwing an investment fund like this doesn't always just stick it to the rich guys...

simonh2• 5 years ago

So what you're saying is you and thousands like you don't mind risking losing money because you think it's worth it to stick it to the man.

Who do you think is making money off all the trades you're losing on? Doh!

Some billionaires will lose money - actually they already did a few days ago when they exited. Some others will make a few millions or billions. Robinhood looks like they've got some explaining to do. Just another day on Wall Street.

dmingod666• 5 years ago

lol, when did the stock market reflect the fundamentals? Its post 2020, the whole economy had come to a standstill and the market was rallying like nothing happened. All this 'fundamentals' talk just sounds hollow.

fock• 5 years ago

it is. the whole market is overvalued. But while some parts of the market have some actual things, people want (highly educated workforce, machinery, land, supply chains...) Gamestop has nothing of this and yet is pushed to an even higher value.

xadhominemx4• 5 years ago

The market rallied because it accurately predicted there would be a strong economic recovery in 2021/2022.

Enginerrrd• 5 years ago

Yeah, tell me the P/E ratios everywhere else in the market right now are rational from a fundamentals perspective and I'll call you either deluded or a liar.

medium_burrito• 5 years ago

By "fundamentals", you mean the government buying corporate bonds and money printer go "brrrr"? Seriously, we Japan now.

bluGill8• 5 years ago

Over any 20 year period the market has always reflected the fundamentals. However over any few months period it has always been a popularity contest.

Note that fundamentals include things like bonds and government manipulation.

ece• 5 years ago

A good hedge fund knows how to hedge the risky investments they make, and if they're just betting, they should know someone else might get the other side. It could be another fund/investor, but it's WSB this time.

I think there's a lesson here for people making massive short bets, and for hedge funds and anybody making a bet instead of an investment: that someone else might take the other side and have more power than you might think. This is all just betting at this point, with WSB still betting they can trigger even more of a short squeeze. If this has somehow crossed the line from "bet" to "investment" that starts affecting the rest of the economy, then the consequences should be interesting to watch. Trading on exchanges shouldn't be able to be restricted by someone like Robinhood, though they have other problems too.

MrPatan• 5 years ago

The SEC should protect the hedge funds by preventing them from short selling

mensetmanusman• 5 years ago

I am glad they addressed the philosophical question of whether shorting the stocks should be illegal.

I have more confidence in our equities markets because of the existence of short sellers. I’m glad to know there are people researching companies that are not being honest about their financials.

If there were another way to incentivize finding these types of companies without short selling, I would be interested.

mschuster91• 5 years ago

If there were another way to incentivize finding these types of companies without short selling, I would be interested.

In ye olde times before the invention and institutionalization of short selling and other financial instruments, this kind of research was the responsibility of the media (to raise the alarm) and the SEC/police (to investigate claims with the authority of the government, and prosecute offenders).

Unfortunately, most newsrooms have been "consolidated" or shut down entirely as the market for quality journalism has declined over the last decades, and there is an unhealthy "revolving door" between banks, hedge funds and other market players on one side, and regulatory agencies on the other side.

kgwgk2• 5 years ago

Short selling is older than the SEC.

pbronez3• 5 years ago

Maybe? I think it’s really useful to give people an economic incentive to do socially useful things, like pointing out when a company is in an unsustainable position before it literally starts locking out workers.

Journalists are better spent digging into political situations that aren’t directly tradable.

Even if you think journalists should do the research and make results public instead of funds doing the research and keeping it private (until they reveal their conclusions through trading), I think you want shorting available as a RESPONSE to the reporting. Why would the companies change their behavior in response to negative press if they aren’t subjected to economic pain for ignoring it?

swiley• 5 years ago

Put options let you take a bearish position without short selling. IMO it's a way less crazy way to do that.

JumpCrisscross2• 5 years ago

Put options let you take a bearish position without short selling

Put options can’t be written at scale without shorting.

bluGill8• 5 years ago

The problem with puts is they have a time frame. I'm bearish, but I don't know when there will be a top. The market can remain irrational long enough for puts to expire worthless.

premiumpocket• 5 years ago

What reddit guys are doing should be called MEMEntum & not momentum

CTDOCodebases• 5 years ago

In reference to the GME/WSB fiasco the issue isn't so much the shorting itself but the large number of “fails-to-deliver”.

This was happening since early December. It looked suspicious and was reported to the SEC. Read comments for receipts.

https://www.reddit.com/r/wallstreetbets/comments/kr98ym/gme_...

ZephyrBlu6• 5 years ago

Which I believe is due to them having shorted over 100% of the float making it impossible for the shares which were shorted to be purchased.

wrkronmiller• 5 years ago

There are 100 shares. A owns 90 of them, B owns 10. A lends her 90 shares to C, who shorts them all to D. Now A owns 90 shares, B owns 10 and D owns 90—there are 100 shares outstanding, but190 shares show up on ownership lists. (The accounts balance because C owes 90 shares to A, giving C, in a sense, negative 90 shares.) Short interest is 90 shares out of 100 outstanding. Now D lends her 90 shares to E, who shorts them all to F. Now A owns 90, B 10, D 90 and F 90, for a total of 280 shares. Short interest is 180 shares out of 100 outstanding. No problem! No big deal! You can just keep re-borrowing the shares. F can lend them to G! It's fine.

https://www.bloomberg.com/opinion/articles/2021-01-25/the-ga...

Threeve3033• 5 years ago

This is a financial version of the social media effect we have seen spreading misinformation and causing people to act in real life.

All of the ingredients are there.

1) Use social media to organize motivated groups of people

2) Align the mob to a target that is inherently disliked. Hedge funds and wall street more generally.

3) Cause world wide market volatility. In this case, it's moving institutional investors out of the market, eventually causing a lack of liquidity that reveals structural problems. In other words, How many Lehman Brothers does it take to cause a 2008 type crash?

bhawks• 5 years ago

You lost me at 3 - how can having hidden structural problems be a desirable position to be in? Hedge funds entered a crowded trade that has unlimited downside without an exit strategy. They are not naive and although they're obviously upset I doubt they're shocked about what happened. They went in with confidence thinking they knew the 'market' (aka other hedge funds) and discounted the possibility of a short squeeze.

This type of risk taking behavior must have the associated consequences, otherwise there is no reason to stop behaving this way at larger and larger scales. Moral hazard - again a finance / trading 101 concept - just like shorting can result in infinite loss.

Threeve3033• 5 years ago

Investors have been known to want increased volatility because playing it right increases profit. If you can target that volatility to specific industries or companies, all the better.

If a foreign adversary was using bots or social media manipulation to drive up this behavior, perhaps they could target the right companies in the market to reveal structural weakness. Similar to how the 2016 election interference happened. Though that is getting much more on the conspiratorial side.

hippich• 5 years ago

Re "spreading misinformation" - not sure which pieces you are specifically talking about. In case of r/WSB I doubt anyone has any illusions what it is about. It is done either for lulz or as a form of protest/activism. In a way - it is form of speech.

Threeve3033• 5 years ago

If bots can hype up conspiracies to target political opponents then why not try it with something in finance?

Basically, astroturf these campaigns to target specific companies in the market. You only need a small dedicated core then the herd follows. As we have seen time and again with social media manipulation.

JumpCrisscross2• 5 years ago

How are the futures hedged if shorting is not allowed? Does that mean every futures seller is effectively unhedged?

pgAdmin4• 5 years ago

I am naive here, can someone explain what is the economic utility of a stock market ?

For example, its easy to understand utility of food, cloths, car, house, money. But I am not able to find a reason about stock market existence for day-to-day trading, where secondary stocks are traded daily after IPO. It seems none of the day-to-day trading money/profit ever goes back to business to help them to improve that business.

cardiffspaceman3• 5 years ago

The utility comes from the utility of having the chance to sell your IPO shares on the day and date of your choosing. That liquidity makes the shares more valuable to the buyer, who might find herself in a "oops I have to sell now" situation.

creamyhorror• 5 years ago

I thought about this long ago.

The answer is that the casino-like activity of the secondary market provides a great incentive to companies to primary-list. This engine drives business formation through the valuations it can provide to companies. And companies can issue more shares to raise more capital from the very liquid casino. So it's helpful in that way.

Shorting and Indian capital markets

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