The market’s hottest stocks are carving out a crucial new role

Heading into Netflix‘s earnings report last week, traders were braced for the worst. With the stock up a massive 30% since January, a measure of bearish bets sat close to its highest level of the year.

The company went on to destroy subscriber forecasts, sending its shares up as much as 14% the next day, costing short sellers more than $US400 million, according to data from IHS Markit.

Now that the dust has settled, those bearish speculators haven’t gone anywhere, with Netflix short interest — a measure of bets that share prices will drop — still perched near highs.

It’s a dynamic that’s played out countless times this year amongst the mega-cap tech cohort that’s been dominating the US equity market. As those companies outperform, traders pile into shorts, only to lose money as the stock market’s relentless chug higher continues.

So why are investors interested in betting against tech titans like Google, Amazon, Tesla and Netflix, even though they’re likely to get burned?

Because the very nature of how these companies are being traded is changing, according to Ihor Dusaniwsky, the head of research at financial analytics firm S3 Partners. He says they’re being used as proxies for hedging the broader stock market — the wisdom being: as these huge, influential stocks go, so does the market.

“Even with these large mark to market losses, shorts are not being squeezed into closing down their positions,” Dusaniwsky told Business Insider. Heavily shorted companies like Alphabet, Amazon and Netflix are “the new non-ETF portfolio hedges. Managers are using short positions in these stocks to hedge their portfolios against large negative market moves.”

Looking at a list of the top 25 US non-exchange traded fund shorts, you can see this dynamic at work. Of the 12 stocks with the highest level of short interest, nine have risen this year to an extent that’s cost traders hundreds of millions of dollars, according to S3 data.

It’s just further proof that many investors don’t mind losing a steady trickle of money paying for hedges, so long as they’re protected to the downside, should anything shock the market.

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Many of the market’s biggest shorts are also the best performers. Investors have stuck with positions despite losing money. S3 Partners