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What You Need to Know About the Impact of Short Selling

A bearish market has led to more short selling.

Short selling - the practice of selling stock before it has been delivered to the seller and buying it back at a lower price - is on the rise, but it has stirred up controversy among some users.

Bloomberg reports that a signal that short selling is occurring, borrowing shares, has increased the most since 2006, jumping from 9.5 percent of stock in July to 11.6 percent in September. Investors across the globe are becoming more bearish, the source says, and may be driven by the fact that economies are slowing down.

Indexes are dropping, the source says, which is not a good indication of things to come - total losses between May and October "exceed the combined gross domestic product of Brazil, Russia, India and China." With investors "tempted to bottom pick" in order to profit even as markets lose money, Alex Au of Richland Capital Management told Bloomberg they may be flirting with danger, as the "worst is yet to come."

Exchange data analyzed by the source indicates that some companies such as GE and Pfizer have also experienced heightened levels of short selling. In the first half of September alone, Pfizer's short sales rose to 111 million shares, representing a 22 percent increase. Over the same period, short sales for GE hit their highest levels since August 2009, rising 13 percent to reach 141 million shares.

"The Lehman collapse is way too clear in people’s minds," Henrik Drusebjerg, a senior strategist at Copenhagen-based Nordea Bank AB who helps oversee $230 billion, told the news outlet. "They don't want to get burned as much again. They know either they get some protection or get out altogether."

Binky Chadha, the chief U.S. equity strategist at Deutsche Bank AG, also invoked the memory of Lehman while talking with Bloomberg. Chadha said that short interest and valuations were "approaching Lehman levels," and added it was becoming more difficult to take increasingly large short positions.

Fitch Ratings says that despite an effort to increase corporate governance, investors that short sell Chinese companies have created market volatility and uncertainty. The agency issued a release at the end of September saying that groups that issued research reports and claim that other companies have committed malpractice and fraud, or have engaged in false accounting, are doing more damage than good when it comes to encouraging greater transparency.

One of the groups that Fitch highlighted was Anonymous Analytics, which alleged that Chaoda Modern Agriculture was conducting less-than-scrupulous practices. This and other groups have reportedly short sold stocks in the companies they "expose" right before publishing their claims, Fitch says.

"Chinese companies provide relatively easy targets for these tactics," the agency said, in part because the analytical investors located in China have not developed as much as those in the West. "Combined with strong growth expectations and a desire by local and foreign capital to participate in this growth process this increases the potential for unusual practices and sometimes fraud."

While the reports create some challenges for investors, Fitch said a potential benefit is the fact that companies may be more likely to question another business' practices and conduct due diligence before proceeding with a deal.

Some are arguing that a short-selling ban be instituted in Hong Kong. Simon Lam, of the Hong Kong Securities Professionals Association, said in an interview with Bloomberg that with more traders putting bets on falls in Hong Kong stocks.

Lam says that considering the fact that other countries frown on "naked"short-selling - when the investor never actually owns the stock he or she sells off - it would be fair for Hong Kong to follow Europe's and the United States' example.