Short Selling and Margin Trading in the Chinese Stock Market

Abstract

Just as market regulators around the world adopt a more rigorous attitude towards short selling and margin trading, Chinese authorities at its first time approve trades on margin in the domestic stock market. With this introduction event, we conduct three empirical studies regarding short selling and margin trading in the A-share market. The first study examines the impact of the dual introduction on feedback trading behaviour and stock volatility dynamics of the underlying stocks. With a combination of the heterogeneous trader model and GARCH-type models, we highlight the conditional nature of return persistence stemming from feedback trading behaviour. Our findings indicate that the introduction of short selling and margin trading contribute to a moderated level of unconditional positive autocorrelation and conditional positive feedback trading. Besides, no evidence shows that the two mechanisms destabilise the stock market by increasing the volatility persistence in stock returns. Rather, the two mechanisms support the informational efficiency and contribute to the stabilisation of the stock market.

With more precise data of each mechanism’s trading activity, the second study investigates the different impacts of short selling and margin trading on the degree of feedback trading and returns volatility at three levels, the individual stock level, the portfolio level, and the market level. Also, we study the impact differences between the trading activity of retail margin investors and that conducted by institutional margin investors. Our results indicate that neither short-selling activity nor margin-trading activity increases positive feedback trading among studied stocks. However, an increasing impact of short selling on negative feedback trading is observed. The strategy of negative feedback trading adopted by short sellers is not conducive to market stability since it does not involve evaluation of a security’s intrinsic value. We also find that margin-trading activity has a significant increasing impact on the level of volatility, while short-selling activity has a slightly decreasing impact. Besides, it reveals that retail investors who have a lower level of financial literacy are more prone to feedback trading strategies. During the stable and booming periods, trades on margin conducted by institutional investors are positively related to a lower level of returns volatility. During the bearish and crash periods, the participation of retail margin investors leads to a higher level of negative feedback trading.

Our third study estimates the determinants of short selling and margin trading respectively with panel regressions of a hierarchical approach. We argue that short-selling (or margin-trading) activity is a function of various factors at both the firm and market level. Taking together with control variables, the firm-level factors considered include past short-selling/margin-trading activity, past stock returns, stock returns volatility, financial ratios, ex-dividend date event, industry classification, insider trading event, stock analyst recommendations, block trading event, whereas the market-level factors include past market performance and investor sentiment. We find that short-selling activity is significantly related to past short-selling activity (+), past stock returns (+), historical volatility (-), EPS (-), financial industry stocks (+), insider sale (+), analyst upgrade (+), block plus-tick order (+), past market performance (+) and CCI (-). While margin-trading activity is decided by past margin-trading activity (+), past stock returns (+), historical volatility (-), EPS (+), ex-dividend date event (-), financial stocks (+), insider purchase (+), analyst upgrade (-), block plus-tick order (+), past market performance (+) and market turnover (+). These results provide crucial insights into the nature of information advantages that lead to abnormal returns earned by short sellers and margin traders.