Short selling, when it is a trading phenomenon, can be seen as a barometer of confidence in an individual company, or a market. The most common reasons for engaging in short selling are speculation and hedging. A short seller is making a purely speculative price bet that a stock or index will decline in the future. It’s very conviction-driven, as if the investor is wrong, they will have to buy the shares back higher, at a loss.
That’s why recent research from Capital.com, the UK-based trading platform, is revealing. The research found that 38% of its traders carried out short-position trades on the platform in the second quarter of 2022. This was 34% higher compared to the previous quarter and marks the highest number of short sellers on Capital.com since 1Q20.
The significant rise in short-position traders—a strategy that enables traders to try and profit from falling asset prices, comes amid a backdrop of declining markets. The findings were revealed in Capital.com’s quarterly report – Pulse – which tracks the trading patterns of retail investors across all markets it operates in. The platform has over 6 million accounts, so the basis for the survey is quite robust.
According to David Jones, chief market strategist for Capital.com, the rising number of short-position traders in Q2 points to a shifting investor mindset as markets turn more bearish.
“As a general rule, self-directed traders and investors seldom short sell. They are so used to buying first and selling later that it’s psychologically very difficult for them to come out of this way of thinking. Our findings show there has been a sharp rise in clients short selling in Q2, which shows just how significant the drop in many markets has been. This may have forced many retail traders to change their mindset,” he said
The research showed that the highest proportion of short trades came from the UK, Africa and Asia (41%). While the lowest proportion of short trades was seen in Australia (34%).
Jones said: “One thing that is interesting is the slightly less short-selling activity by Australian clients. One explanation for this could be the relative resilience of the Australian stock market index this year. The Australian ASX 200 index only started falling in May – it had been volatile but broadly sideways for much of the year since then. Perhaps Australian clients felt somewhat insulated from the market meltdown that was underway in most other areas of the world, so have come to short-selling a little later than those in other regions.”
Capital.com also revealed that short selling was slightly more profitable (32.1%) than long-position trades (28.7%) during the period.
“The ability to sell-short could well have an impact on traders’ overall profit and loss. This could be particularly true if we enter a period of prolonged weakness in markets, where investors stop being rewarded for just blindly buying the dip. Using sensible risk control measures such as stop losses in tandem with short selling could be a prudent addition to a trader ‘s overall strategy,” said Jones.
A dollar short
The research also revealed that foreign-exchange markets were heavily traded in the last quarter, with traders around the world shorting the US dollar’s prospects against other currencies, particularly the Japanese yen. In all regions except the UK and Africa , the US dollar versus the Japanese yen (USD/JPY) was the most traded currency pair.
“Bank of Japan (BoJ) governor Kuroda has remained steadfast against tightening monetary policy as inflation is benign in Japan compared with the US, where the Fed has embarked on its aggressive rate hike cycle. However, the Fed’s well-signposted future rate hikes are likely priced in by markets. Any future hawkish pivot from the Bank of Japan, therefore, could drive the yen higher in the coming months, and finally put some pressure on the US dollar,” noted Jones.
The other two most shorted markets in the second quarter were commodities and indices. Shorting the Nasdaq proved more profitable in Q2, recording a higher percentage of profits (33.7%) than long positions (32.6%).
“Buying the dips was a very profitable strategy through much of 2021 – but it has of course been a different story this year with the NASDAQ100 under pressure for much of the year so far. The index had a strong bounce back towards the end of March – but once again this rally hit the buffers, and the index lost 22% in the second quarter. Perhaps those traders who had been trying to buy the dip in the first quarter – and getting their fingers burnt – decided to throw in the towel and join the short sellers in the second quarter. The NASDAQ 100 did show the tentative signs of trying to form a base during June which should make for an interesting third quarter as the battle between the bulls and bears continues,” said Jones.
Oil not so slick
Across commodity markets, oil was the most shorted during the period. In Q2, 41% of all oil CFDs traded on the Capital.com platform globally were short, up from 35% in Q1.
“It is perhaps not too surprising that more traders have been taking the view that the market may have become overheated. Oil has rocketed more than 500% from its lows in April 2020 and the global commodity index (S&P GSC) has more than doubled its value. At its peak this year, following the Russian invasion of Ukraine, oil was up 70% for the year to date – and this was before we were even three months into the year,” said Jones.
“…With short positions in oil climbing, perhaps traders are expecting benchmark crude oil rates to drop over the next three months. If inflation continues to pressurise the world economy, then that could further feed through to weakness in the oil price.”
Short selling can be quite disruptive in the markets, and the some of the more-opaque practices are drawing the attention of regulators. South Korea is leading the way in curtailing naked shorting in retail markets. On 28th July, South Korea’s Financial Services Commission, the Financial Supervisory Service, the prosecution and the Korea Exchange released a new plan for more effective short selling monitoring.
The Korean’s concerns over the market practice refer to illegal short selling and will start monitoring the practice of naked short selling. Naked shorting is the illegal practice of short selling shares that have not been affirmatively determined to exist. Ordinarily, traders must borrow a stock or determine that it can be borrowed before they sell it short. So naked shorting refers to short pressure on a stock that may be larger than the tradable shares in the market.
Despite being made illegal after the 2008/09 financial crisis, naked shorting continues to happen because of loopholes in rules and discrepancies between paper and electronic trading systems. According to the Korean plan, regulators and prosecutors will expand investigations into illegal short selling while conducting regular monitoring of naked short selling. The prosecution will utilize a special investigation procedure so that reviews at the Securities and Futures Commission can be omitted and cases can be brought to court within one to two years instead of two to three years.
At the same time, stocks with a short selling ratio of 30% or more will be subject to special monitoring once the price falls 3% or more or the trading volume at least doubles. In addition, the short selling ban on a certain stock will be automatically extended once its price falls 5% or more on the day of the ban.
Short selling by individual investors was previously made easier in South Korea, it seems now the regulators are starting to rein in the practice. Specifically, their minimum required security has been lowered from 140 percent to 120 percent and indefinite stock lending and borrowing will be facilitated for individual investors classified as professional. The plan is scheduled to become effective this autumn.
The benchmark Korea Composite Stock Price Index has seen about a quarter of its value (-24.96%) wiped in the last year.
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