Can Short-sellers Predict Returns? Daily Evidence
Social Science Research Network
We test whether short-sellers in Nasdaq-listed stocks are able to predict future returns based on new SEC-mandated data for the first six months of 2005. There is a tremendous amount of short-term trading strategies involving short-sales during the sample: Short-sales represent 27 percent of Nasdaq share volume while monthly short-interest is about 3.1 percent of shares outstanding (5.5 days to cover). Short-sellers are on average contrarian -they sell short following positive returns.
... e returns. Increasing short-sales predict future negative returns, and the predictive power comes primarily from small trades. A trading strategy based on daily short-selling activity generates significant returns, but incurs costs large enough to wipe out any profits. Stafford (2002)) to investigate if short-sale constraints contribute to short-term over-reaction in stock prices, and if short sellers are informed. The general conclusion reached by this literature is that short-sale costs are higher and short-sale constraints are more binding among stocks with low market capitalization and stocks with low institutional ownership. The literature also finds that high shorting demand predicts abnormally low future returns both at the weekly and monthly frequency. To our knowledge, no one has examined whether short-sellers are contrarian or momentum traders. Our data has several advantages compared to the previous literature. We are able to distinguish short-selling by investors who are subject to short-sale rules from market makers that are exempt. Our study focuses on short-selling by non-exempt traders. This is important since market makers will tend to be contrarian investors due to their role as intermediaries. We can identify trade size, and hence can use the dollar size of trades to proxy for short-selling by institutional investors. Moreover, the data allows us to study daily (and even intradaily) shorting activity. Hence, we can capture patterns of short-selling which would never appear in the monthly short interest data. The main drawback with the data is that we cannot capture the ultimate covering of short-sale trades. We find a tremendous amount of short-selling in our sample. Short-sales represent on average 26.7 percent of Nasdaq reported share volume. By comparison, average monthly short interest for the same period is about 3.1 percent of shares outstanding (5.5 days to cover). Hence, we conjecture that the high fraction of short-sales in daily volume is caused by short-term trading strategies. This extensive amount of short-term short-sale strategies cannot be explained by the activities of equity and options market makers (exempt from short-sale rules). Short-selling by exempt traders represents only 7.8 percent of reported share volume, leaving the remaining 18.9 percent to traders subject to short-sale rules. The question then becomes, how do Nasdaq short-sellers trade? Do they "pile on" after poor returns as the critics would have it, or do they act contrarian (i.e., sell when they observe a shortterm over-reaction)? Based on our sample, there is no evidence of short-sellers systematically "piling on." In fact, short-sellers actually decrease their shorting activity following negative abnormal returns. Instead, we find strong evidence that short-sellers are contrarian; they increase their short-selling activity following positive abnormal returns.