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How does the auction market work against & in favor of short-sellers?

Auction marketplaces are a great method to bring buyers and sellers together. An auction market is exemplified by the New York Stock Exchange (NYSE). When an offer and a bid are matched on the exchange, a trade is completed — thinks of it as a price agreed upon by the buyer and seller. Negotiations take place in OTC markets, while none take place in auction markets.

Historically, auction market trades were conducted using an open outcry system, in which buyers and sellers called out prices on the trading floor. Currently, trades in an auction market are completed electronically and are matched simultaneously and instantly. If the bid cannot be matched to an offer price, the order will be placed on hold until a matching bid and ask can be found. The procedure is shared over many buyers and sellers in an exchange.

The concept of short delivery is distinct from the delivery you receive when you buy a stock. When a trader takes a short intraday position by selling shares, he must cover his position the same day by buying those same shares. However, if he fails to do so for any reason, his trade position will indicate selling shares without having received any delivery. Short delivery is the word used to describe such a delivery position of shares.

If you already have a delivery of shares, you must deliver them within two days after selling them; however, this is not possible with a short delivery because you do not have any shares in your Demat account to cover the short sell. In this case, you'd have to settle for quick delivery. This will result in a stock auction.

They are termed closed out when there is a short delivery of shares and the exchange finds no new sellers in the auction markets. Instead of providing the shares to the buyer, the exchanges settle in cash based on the close-out rate.

The stock that was short delivered will be closed out at the highest price in the exchange from the day of trade until the auction day, or 20 percent above the official closing price on the auction day, whichever is higher. This information is subsequently sent on to the buyer. Consider it as a form of compensation for the buyer in the event of non-delivery of shares.

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For Example -

Assume you purchased 100 ITC shares at Rs. 700/- per share, and these shares were short delivered, resulting in you not receiving delivery on T+2. The Exchange then conducts an auction in which it attempts to locate new sellers who can deliver 100 shares of ITC to you. The trade is completed by a close-out if there are no new sellers in the auction markets.

Assume that on the auction date (T+2) the official closing price of ITC was Rs. 800/-. In this situation, the Exchange would conclude the trade at Rs.960/- (20% higher than 800), and the defaulting stock seller would be responsible for an auction penalty of Rs.16, 000/- (960-800*100). As a result, the bidder would receive a total of Rs 96,000/- (Rs 80,000, i.e. the closing price on the auction date + Rs 16,000, which is the auction penalty).

If the price of ITC had reached 980 (from the day of trade to the auction day), the closeout is done at Rs. 980, not Rs. 960, because it is greater than the closing price + 20% auction penalty of ITC on the auction day. The buyer of the securities will be reimbursed with a credit of Rs.980 per share in such a circumstance.

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