Essays on short selling

Abstract

The purpose of this thesis is to study the trading behavior of short sellers. More specifically, we are interested in the information content embedded in disclosed short positions and the effects of short-selling restrictions. In the first chapter, we infer investors’ expectations about future stock returns through a measure of short conviction that exploits net short positions disclosed at the investor-stock level for European stock markets. A strategy that sells high-conviction stocks and buys low-conviction stocks, named Best Short, generates a risk-adjusted excess return that is larger than 8% per annum and differs from the performance of traditional strategies based on aggregate short interest. Its profitability, moreover, cannot be explained by transaction costs, stock characteristics, frictions in the securities lending market, leverage constraints, and measures of price efficiency. In the second chapter, we investigate whether short sellers are informed when they exit their positions, using publicly disclosed short positions in European stock markets. We find that short covering trades are associated with positive price impact, and future abnormal returns depend on whether short sellers exit their positions at a profit or at a loss. When short sellers close profitable short positions, we find evidence that future abnormal returns are positive. In contrast, when short sellers cover their trades at a loss, future abnormal returns are negative. Our results suggest that short sellers are generally informed when covering their shorts, but they are also sensitive to limits to arbitrage leading them to sometimes close their positions prematurely. In the third chapter, we present a theoretical framework to study the effects of short-selling bans on markets, and we test its predictions using cross-sectional variation in the European 2020 short-selling bans. The model’s novelty is in the way that institutional ownership affects the conditions under which bans help avert a sharp decline in prices. Empirically we find, consistent with the model, that tail risk was reduced in countries that implemented short-selling bans, and that this effect was more pronounced in stocks with low institutional ownership. However, bans were detrimental for liquidity and failed to support the average level of prices.