Is Short Selling Getting the Short End of the Stick? Research Shows That Short Sellers Base Their Trades on the Same Information Everyone Else Has and That Efforts to Restrict Them Have Adverse Consequences throughout the Market

Article excerpt

THE TRANSACTION BETWEEN one investor betting that the value of a stock will go in one direction and another investor betting it will do the opposite creates the engine that powers the stock market. Investors mix public knowledge with their own analysis and add a dash of hunch to move forward with the trade, confident that they are right and that their counterparts are wrong.

Although one person is more right than the other in every transaction, and the investor who bets right ultimately is happier with the trade, buying and selling on the open market has proceeded without moral judgment. That is, until the financial market fell into dire straits in 2008 and short sellers who made money (while many investors lost big) were eyed with suspicion.

Short sellers sell shares they have borrowed, intending to buy them back once the price has dropped. Essentially, they bet against the success of a business, an industry, or an entire country. When they were right and reaped profits while the rest of the economy went into a tailspin, they drew mutterings that they might have fomented the price drops from which they profited.

In response, the Securities and Exchange Commission (SEC) adopted two temporary rules in 2008 to constrain short sellers, who were blamed for some of the patterns in stock prices during the financial crisis that began in March 2008. The rules changed the way short sellers borrowed stocks and limited their ability to trade. Sometimes the best intentions have negative consequences, however, and the limits greatly increased the cost of short sales. Over time, the rules came to hurt other trading too.

The rules may have been premature. This author's research indicates that short sellers base their trades on the same information available to everyone else in the market, and that efforts to restrict short selling have deleterious consequences throughout the market. The results of a study this author conducted with finance professor Joseph E. Engelberg and doctoral student Matthew C. Ringgenberg of UNC Kenan-Flagler Business School show that concerns about short sellers manipulating the market are unfounded. (1) More likely, short sellers do well because they research companies more thoroughly than most traders and their analysis of publicly available information is more astute.

Correlating Trade Time and Success

For our study, we built our research on overwhelming evidence that short sellers are informed traders. They have a track record of betting correctly and therefore become market leaders whose actions others follow. But return predictability tells us little about how short sellers obtain an informational advantage. In our research, we combined a database of short sellers' trading patterns with a database of news releases.

Our information source contained all short sales involving stocks listed on the New York Stock Exchange from January 2005 to July 2007 and showed the exact time and price at which each short sale was executed. We compared the timing of short sales with the publication of news articles about the companies whose stocks had been sold short. In the vast majority of cases, short sellers reacted to news articles at the same time the rest of the market did. The ratio of short-sale volume in a given stock to overall trading volume remained virtually constant over a period beginning three weeks before the typical news article about that stock and lasting for three weeks after. We found the same results when we focused only on articles that reported negative information about the stock's underlying company.

Not only does our research suggest that short sellers do not uncover and trade on information before it becomes publicly available, but in the instances when the timing of the short sales did deviate from the timing of other types of trades, more often than not the short sellers reacted to the information later rather than earlier. …