Suppose, you believe that with the Indian, Japanese and the Southeast economies showing distinct signs of recovery, regional trade is going to grow sharply. The quantity of freight is going to increase sharply and as a consequence, there is going to be a firming up of freight rates, particularly in the shipping sector. Furthermore, you believe that Indian shipping companies will turn in bumper profits in the coming quarter, as a fallout of this. To capitalise on the opportunity, you wish to take a large position in a domestic shipping company. But there is a catch. You do not have the money to invest in a shipping stock, say for example, Great Eastern Shipping (Gesco).
However, you need not worry. The Indian bourses (the Bombay Stock Exchange (BSE) in this case) offer facilities to investors to capitalise on these opportunities. It gives them an opportunity to either go long (purchase) or go short (sell) in a stock over a period that goes beyond just one settlement.
A long purchase implies having bought a stock, which has a positive outlook, without having paid for it, with the intention of squaring off the deal at a profit in the future. The momentum investor can do this by selling off his outstanding position at a higher price. A short sell on the other hand is aimed at capitalising on the pessimism prevailing in the market (or the stock in particular) by selling shares, without actually possessing them. The momentum investor in this case is looking forward to square off the deal by purchasing back the shares sold, at a lower price.
This system is popularly referred to as badla. There are certain rules and regulations that have to be complied with while doing badla. Some important ones are enumerated below:
- Badla can be done in only A group shares on the BSE.
- A badla trade has to be necessarily squared off within 90 days of entering into such a trade.
- Margin money of 15%, both on long and short positions, (sometimes set arbitrarily for some stocks) will have to be maintained on a daily basis with the broker.
- The outstanding position will be carried forward to the next settlement at a 'badla rate' (financing cost), mutually determined by the borrower and financier. The badla rate will be payable on the making up price (or Hawala rate, nearly equal to the closing price of the stock at the end of the settlement).
Take for example a momentum investor has gone long on 100 shares of Gesco.
At the end of the settlement the BSE will publish the details regarding carry forward, which in this case are:
As the margin in this stock has been set at 20%, the investor will have to keep a margin of Rs 4.75 per share with the broker. The special making up price indicates the net outstanding position (per share) at the end of the settlement.
The investor will then have to finance his position (equal to the hawala/making up rate) at a special badla session that is held after the close of the settlement. In this case, one will have to pay financing charges (vyaj badla) on Rs 2,300 (23*100) for the period until the next badla session. The deal then gets carried forward to the next settlement.
In this way, an investment of just Rs 475 (4.75*100) let's you take on a position of Rs 2,300. And if by the end of the next settlement the increase in the value of the investment is greater than the financing cost that has been paid, then you make a profit. However, in the opposite case, your losses are deepened, as you suffer erosion in value and also pay financing costs.
On the other hand, if one has gone short, then one would have to pay charges to borrow stock (share badla).
Sometimes, it may happen that there are a large number of short sellers in the market and the person who has gone long actually demands delivery. This means that the investor holding the long position decides to take delivery and pay up for the same. If the short sellers are unable to find a person to lend stock (share badla) then they will be faced with a possibility of default. This is called a bear trap. The short sellers will then have to pay the investors, who have gone long, so that they desist from taking delivery. The charge so levied is called 'undha badla' and is an uncommon feature in the markets.
The gross carry forward positions on the BSE were in excess of Rs 35 bn at the end of the settlement that ended on 22nd October 1999. This underscores the importance of the system to the stock markets. However, it must be said that trading on the badla account is like a double edged sword - it maximises profits and deepens the losses.