Short-Sale Strategies and Return Predictability

Abstract

We examine short selling in US stocks based on new SEC-mandated data for 2005. There is a tremendous amount of short selling in our sample: short sales represent 24% of NYSE and 31% of Nasdaq share volume. Short sellers increase their trading following positive returns and they correctly predict future negative abnormal returns. These patterns are robust to controlling for voluntary liquidity provision and for opportunistic risk-bearing by short sellers. The results are consistent with short sellers trading on short-term overreaction of stock prices. A trading strategy based on daily short-selling activity generates significant positive returns during the sample period. (JEL G12, G14) There is currently tremendous interest in short selling not only from academics, but also from issuers, media representatives, the Securities and Exchange Commission (SEC), and Congress. Academics generally share the view that short sellers help markets correct short-term deviations of stock prices from fundamental value. This view is by no means universally held, and many issuers and media representatives instead characterize short sellers as immoral, unethical, and downright un-American. 1 In an attempt to evaluate the efficacy of

Short selling in initial public offerings☆

“…These findings are consistent with Diether, Lee, and Werner (2009a) who find that short sellers are contrarians who ''increase their trading following positive returns.'' However, our results do not support the role of short sale constraints in divergence of opinion models of IPO pricing, as short selling and firstday returns are positively related.…”

“…The average level of short sales on the offer day exceeds 7% of the shares offered and subsequently declines over the first month of trading. By the fifth trading day, the ratio of short selling to volume is only slightly lower than that shown by Diether, Lee, and Werner (2009a) for a large cross-section of stocks. We interpret this finding as an indication that the level of short selling in IPOs quickly approaches an ''equilibrium'' level.…”

“…4, the level of short selling quickly levels off by the fifth or sixth trading day. 18 Although the magnitude of short sales as a percent of volume remains lower for NYSE IPOs (15%) and Nasdaq IPOs (25%), than that found by Diether, Lee, and Werner (2009a), it appears from Fig. 4 that short selling as a percent of volume begins to approach average levels very quickly.…”

“…If the investor were to use allocated shares for delivery on T+3, this would constitute a long sale. Diether, Lee, and Werner (2009a), find that short sales constitute approximately 24% of the daily trading volume in NYSE-listed stocks and 31% of volume in Nasdaq-listed stocks. As shown in Fig.…”

“…8 In the case of IPOs needing price support, the underwriter will purchase shares in the open market to cover the overallocation. 9 These overallocated shares could result in fails to deliver if investors sell them before the 2 While short selling is slightly below that shown by Diether, Lee, and Werner (2009a) by the fifth trading day, the level of short selling as a percentage of volume on the first trading day is lower than that reported for a typical stock. The difference in short selling on the first trading day in an IPO, as compared to seasoned stocks, may be due to the fact that the volume on the first trading day is extremely large.…”