The following is an analysis of the Financial Services Commission's recent decision to tighten regulations on the short-selling of stocks. The author is an analyst of Shinhan Investment Corp. He can be reached at email@example.com. -- Ed.
The Financial Services Commission (FSC) announced on March 10 that it will tighten regulations on the short-selling of stocks for three months (March 10-June 9). During that period, the bar for designation as an overheated short-selling stock will be lowered and the short-selling ban for designated stocks will be extended to 10 trading days.
Previously, a hike in short-selling trading volume and decline in share price in excess of normal levels led to a one-day short-selling ban on the following trading day in order to caution investors and stabilize market sentiment.
In light of the rise in stock market volatility caused by the COVID-19 pandemic and sharp oil price declines, the FSC decided to tighten short-selling rules but stopped short of placing a temporary ban on the short-selling of all stocks as it had done during the 2008 financial crisis and 2011European fiscal crisis.
Amid growing volatility in the stock market, the portion of KOSPI/KOSDAQ stocks with share price correction exceeding 5% jumped from 4.9% in January to 6.7% in February and 8.5% in March. The short-selling ratio (short-selling transactions/total trading volume within a trading day) also increased from 3.8% in January to 5% in February and 5.9% in March, contributing to market correction.
Applying the tightened rules to data from January through March 2020, we find that the number of stocks subject to short-selling restrictions would have increased by 3.7x vs. actual levels in the KOSPI market (45 →166 stocks) and by 3.4x in the KOSDAQ market (89 → 304stocks).
For example, as the KOSPI plummeted by 4.2% on March 9, a total of 12 stocks including Samsung Heavy Industries were designated as overheated short-selling stocks under previous rules. If the new rules had been applied, the number would have been significantly higher at 49 stocks, including S-Oil and Korea Shipbuilding & Offshore Engineering.
Designation of overheated short-selling stocks does not limit share price correction but instead aims at preventing additional share price declines sparked by short-selling after sharp correction.
Stocks recording an abnormal surge in short-selling transactions are designated as overheated short-selling stocks. The increase in short-selling transactions is calculated by dividing short-selling trading volume within a trading day by the average short-selling trading volume of the previous 40 trading days. As such, stocks with relatively low short interest ratio are more likely to be designated as overheated short-selling stocks. Stocks likely to be designated as overheated short-selling stocks under the new rules record an average short interest ratio of just 1.9%.
Based on the criteria below, we have compiled a list of stocks that are highly likely to be designated as overheated short-selling stocks under the new rules, which should help to prevent additional share price declines sparked by short-selling after sharp correction.
1) YTD maximum short-selling ratio: 15% or higher
2) Current and YTD average short-selling ratio: 5-20%
3) Maximum-average short-selling ratio gap: 10%p or higher
4) Short interest ratio: 5% or lower.