Short sellers are moving in...and cleaning up

The turmoil in global equity markets this week might have left traders moving to safe havens or even hiding under their desks, but some savvy investors have been loading up on the short side of the trade as stocks have been plummeting southwards.

Short selling is an investment tactic where a speculator borrows a financial instrument, such as a stock, and sells it in the hope of buying it back later at a lower price, thereby making a profit. Research firm Markit measures this short interest by calculating the amount of shares that are out on loan.

"Average short interest in S&P 500 companies now stands at an 18-month high after steadily increasing in the last few months," Simon Colvin, a research analyst at Markit, said in a new note released on Friday morning.

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"The ten most shorted companies a month ago have fallen nearly twice as hard as the rest of the market."

2013 proved a difficult year for these bearish investors as equities continued their seemingly unstoppable path upwards helped along by the extra liquidity provided by global central banks. The S&P 500 clocked gains of 30 percent last year but has only managed a rise of 0.8 percent year-to-date. Since its record high in mid-September the U.S. benchmark has fallen 7.4 percent. European markets have suffered even more with the U.K.'s FTSE 100 moving into a technical correction on Thursday and Greek and Portuguese indexes in bear market territory.

NYSE New York Stock Exchange traders markets
Brendan McDermid | Reuters

The average demand to borrow shares - a proxy for short selling - in S&P 500 constituents stood at 2.2 percent outstanding a month ago, according to Markit. This now stands at 2.4 percent of shares outstanding for the month ending October 15 – the highest level since April last year.

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Data from U.S.-focused research tracker Lipper on Thursday evening showed that U.S. retail investors pulled a net $1.5 billion from their accounts for the week ending October 15. However, U.S. institutional investors appeared to add a net $4.3 billion to equity exchange-traded funds - known as ETFs. This could seem surprising in the bearish climate, but Lipper suggested that these ETF inflows were likely due to large banks and institutions creating additional units for their clients to short sell.

This theory is proven by a similar downdraft in the markets during the depths of the financial crisis of 2008, according to Jeff Tjornehoj from Lipper. Bank of America Merrill Lynch also saw a similar move in its more globally focused research. For the week ending October 15, it saw the biggest outflows from European equity funds ever on record. It also saw "huge" inflows into small cap funds and energy funds, adding that this was "probably" due to ETF creation for new short positions.

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U.S. mining firm Cliff's Natural Resources was top of the most shorted list for the S&P, according to Colvin, with shares falling 37 percent in the last month and 63.7 percent year-to-date. Coal company Peabody Energy was also high up on the list as were retailers such as Kohl's and Gamestop. Colvin noted that on the whole short sellers had failed to cash in on the push lower for oil prices, and consequently oil producers. Nonetheless, that could be about to change with the energy sector seeing the second largest jump in average short interest in the last month, according to Colvin.