Short Selling: a Summary of New Research

Ahead of a discussion of short selling at Bloomberg in London this Wednesday, click here for more information, I went to Madrid last week to listen to various new papers being presented at IESE Business School. Short selling remains a hot topic for finance academics and many of the conclusions reached in these papers confirm that short selling is a valid investment approach and the observations can be used for the benefit of the securities finance community to defend their industry as well prompting some trade ideas for the buy side. The key findings are below with a summary of each paper following that:

• The short selling bans were detrimental to liquidity, especially for small cap stocks and those with high volatility and no listed options.
• Shorting typically takes place after new news and it is the ability of short sellers to quickly analyze the repercussions of such news that is their key skill.
• In the week prior to scheduled earnings, shorting activity could provide some insight into the direction of the earnings surprise and the stock price reaction on that day.
• There are two very distinct types of short sales: those that provide liquidity and those that demand it. Shorts that supply liquidity do so when spreads are unusually wide. These short sellers are also strongly contrarian, stepping in to initiate or increase a short position after fairly sharp price rises. Shorts that demand liquidity tend to be short term momentum traders.

All papers can be downloaded here: http://www.iese.edu/en/ad/ciif/1011/HTMLS/XMADRIDFINANCEWORKSHOP.asp

“Short Selling Bans around the World: Evidence from the 2007-9 Crisis” Alessandro Beber, Marco Pagano
The disruption caused by short selling bans is close to the heart of all those involved in facilitating short selling and people are eager to see evidence to support the instinctive view that these bans made no difference and made markets less efficient. This paper goes a long way to prove the harmful effects of the ban even if Alessandro came in for some tough questioning from his fellow academics regarding “endogeneity” ( the effects observed weren’t cause by the ban itself but by other characteristics of these firms and/or markets.)

The main findings are that the bans were detrimental to liquidity, especially for small cap stocks and those with high volatility and no listed options. It slowed down price discovery (especially for bad news) and failed to support stock prices, except possibly for U.S financial stocks. However, Professor Boehmer pointed out that given that timing of the TARP stimulus announcement it is likely that this was the main reason financials recovered at that time. This is good reading for practitioners and informative for regulators.

“How are shorts informed? Short Sellers, News, and Information Processing” by Adam Reed, Joseph Engelberg and Matthew Ringgenberg

Adam Reed and his colleagues at the University of North Carolina are particularly interested in this area as judged by the annual forum they do with the RMA in the US. Prior academic literature tells us that short sellers tend to be informed and this paper seeks to understand the source of their informational advantage. Popular perception is that short sellers are super human and influence the public’s perception of reality by trading before news announcements. Conversely, using US short sales data from 2005 to 2007, Adam Reed et al conclude that shorting typically takes place after new news and it is their ability to quickly analyze the repercussions of such news that is their key skill. This tallies with the findings of Macquarie’s quant team in their study using the Data Explorers data.

The types of news that attract the most new shorting post announcement is analysts’ comments or ratings, earnings, earnings projections, joint ventures and stock ownership. They also find that, “short sellers’ ability to predict future negative returns are concentrated around news events.”

Complimentary research has been done by Ekkehart Boehmer, Charles Jones and Xiaoyan Zhang, “What do short sellers know?”

Using 5 years of NYSE data they find that short sellers are most active around analyst recommendations changes. Further, “Results suggest that other investors should focus on shorting activity in the week prior to scheduled earnings….shorting activity could provide some insight into the direction of the earnings surprise and the stock price reaction on that day…Each one standard deviation of additional shorting in the cross-section leads to returns one week later than are almost 10% lower on an annualized basis.” The authors believe 75% of the underperformance of heavily shorted names remains unexplained however.

“Shorting at close range: a tale of two types” by Charles Jones, Carole Comerton-Forde, Talis Putnins
Charles Jones of Columbia Business School and his co authors address the key topical questions: do short sellers improve market efficiency? Do they destabilize prices in any way and do they improve or worsen market quality? They use trade level short sales data from the NYSE and NASDAQ exchanges for the first 8 months of 2008. “We find two very distinct types of short sales: those that provide liquidity and those that demand it. Shorts that supply liquidity do so when spreads are unusually wide. These short sellers are also strongly contrarian, stepping in to initiate or increase a short position after fairly sharp price rises…”

Shorts that demand liquidity tend to be short term momentum traders. “We also find that aggressive order flow from short sellers is not very different from aggressive order flow from that originates from long sellers. And finally, “Based on our close-in examination of the data, the evidence provides no reason to target short sellers over other sellers.”