Why the Reddit Trading Frenzy and Short Selling Won't Work in China

  • Short selling refers to a trading strategy that allows investors to bet that the price of a stock or security will fall.
  • In the last two weeks, members of the WallStreetBets online forum encouraged the bidding up of shares that hedge funds have shorted, resulting in a surge in some stock prices and losses for those funds.
  • Analysts say its unlikely something similar would happen in mainland China given tight regulation and online censorship.

BEIJING — The recent short selling frenzy on Wall Street will not likely come to China, where there are many more market restrictions.

Short selling refers to a trading strategy that allows investors to bet that the price of a stock or security will fall.

To short a stock, investors borrow shares and sell them, then ideally buy them back at a lower price later, and pocket the profits made. If the share price does not drop, the short seller will try to minimize losses by buying back the stock, which now costs more.

Investors in mainland China have a limited ability to short stocks — a sign that the local markets are still immature. Tight regulation and online censorship in China also contribute to different investor behavior versus that of the U.S.

Since last month, millions of individual investors have piled into the WallStreetBets forum on Reddit, encouraging one another to bid up shares of stocks that hedge funds have shorted, or bet would fall in price.

A rush of trades through stock brokers like the free Robinhood app caused shares of heavily shorted stocks like GameStop, a video game retailer, to surge 400% in a week.

Shares of GameStop and others that were targeted by the Reddit community have since fallen drastically — but not before some funds betting against them lost billions of dollars.

Why Chinese stock markets are different

Here's why analysts say something similar won't likely happen in China:

First, the concept of short selling is relatively new and limited in scope in the country, where authorities are on high alert for controlling risks.

Regulators only started to allow short selling about 10 years ago and it remains well below 1% of the total market value.

The process is essentially the same as the U.S. Traders profit by borrowing shares, selling them and then buying them back after prices drop.

But one difference in China is that regulators only allow investors to short a portion of stocks traded on the Shanghai and Shenzhen stock exchanges.

The list of stocks — roughly 1,600 or more of them — changes regularly and typically only includes companies with good fundamentals, according to Bruce Pang, head of macro and strategy research at China Renaissance.

That contrasts with the short selling environment in the U.S., where dedicated funds typically pick companies like GameStop for perceived weaknesses in their businesses.

Limited ability to short Chinese stocks and caps of 10% or 20% on daily price moves gives speculators more incentive to pursue different money-making strategies, such as driving prices up before selling.

In the U.S., trading of individual stocks might be paused for excessive volatility, but prices can ultimately soar or plunge – like GameStop's surge of more than 130% one day and a 44% plunge the next.

Stability at all costs

Chinese regulators prioritize stability when forming economic and financial policies — even if they would like to improve the business environment by attracting more foreign investors and increasing the role of stock markets in financing Chinese companies.

That mentality has affected local stock investors, who tend to assume implicit government support means Chinese stocks will only rise. Local interpretation of official signals have also spurred bouts of speculation in the mainland stock market, causing many to nickname it a "casino."

But with millions of ordinary individuals, rather than institutions, dominating Chinese stock trading, regulators are keen to prevent widespread losses as a way of ensuring stability.

That means authorities will take extra precautions to control markets, and it would be very difficult for a large group of retail investors to incite the frenzy seen recently in U.S. markets.

All short trades and online discussion of stocks are closely monitored, Pang said. So in a sense, protection of investors in China is greater than that of more developed markets, he added.

Copyright CNBC
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