What determines the level of short-selling activity?

Financial Management (Financial Management Association), Winter, 2007 by Hung Wan Kot

I test several explanations for the short-sale trading for a sample of the NYSE and the Nasdaq stocks during the 1988-2002 period. I find that short-selling activity is positively related to arbitrage opportunities and hedging demand, and negatively related to previous short-term returns. ANOVA analysis shows that the stock option listing is the most dominant variable in explaining the short-selling level The short-selling level is more positively related to the dummy variables for convertible debt and option listing during the bubble period, suggesting that there was more room for arbitrage opportunity during that volatile period.

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In this paper, I offer four hypotheses to explain the motives for short-selling activity, the Trend Hypothesis, Overpricing Hypothesis, Arbitrage Hypothesis, and the Taxation Hypothesis.

Many earlier studies that examine the motives for short selling either use limited data or are focused on a single issue, such as the Taxpayer Relief Act of 1997. My study investigates several different reasons for short selling. To do so, I use a more extensive data set. In addition, I use an ANOVA analysis to determine which variables matter most to the level of short selling. Furthermore, since my study includes the Dot Corn boom and bust period from 1998 to 2002, I also examine whether there is any difference in short-selling behavior between the bubble period and the 1988 to 1997 non-bubble period, especially for the Nasdaq stocks which were widely believed to have been overpriced during the bubble. Even though there was significant overpricing during the bubble period, short-sellers also had to bear a higher risk of short selling, as the stock market was more volatile and the price might have diverged even further from the fundamental levels. Therefore, I wish to see whether the behavior of short selling during the non-bubble and bubble periods is different.

The evidence supports all of the hypotheses except for the Taxation Hypothesis. In general, I find that the short-selling activity is negatively related to previous one-year return, which is consistent with the Trend Hypothesis, and positively related to dummy variables for convertible debt and preferred stocks, option listing, and merger and acquisition activity, which supports the Arbitrage Hypothesis. My results show that the short-selling level is negatively related to the book-to-market ratio for the Nasdaq stocks but not for the NYSE stocks. ANOVA analysis shows that a stock option listing is the most dominant variable in explaining the short-selling level, on both the NYSE and the Nasdaq. Results between the bubble and non-bubble periods are also slightly different.

The paper is organized as follows. Section I provides a rationale for short selling and describes the four hypotheses. Section II describes the data and variable construction. Section III provides the preliminary statistics. Section IV reports the regression analysis. Section V concludes the paper.

I. Rationale for Short Selling

A short sale is a sale of stocks that a broker or investor does not own, but has borrowed from a brokerage house, a large institutional investor or another broker-dealer. The short-seller establishes his position when selling the borrowed stocks and his position will close when the short-seller purchases the stocks in the market at a later time and returns it to the lender's account. The short-seller will gain if the stock price decreases and lose if the stock price increases.

Short selling is riskier and more costly than opening a long position. The first risk the short-seller faces is the unlimited stock price increasing, especially in the bubble period. In other words, the maximum gain from short selling is the current stock price level when the stock price declines to zero. The maximum loss is unlimited, because the stock price increase is unbound. Second, the short-seller must reimburse the lender any dividend or other distributions paid to the shareholders of the shorted stock. Third, all profits from short selling are taxed as short-term capital gains no matter how long the short position has opened. Fourth, the US Securities and Exchange Commission requires short-sellers to sell only a "plus tick" or a "zero plus tick", i.e., when the stock price has increased. (1) The proceeds from short selling are not available to the short-seller. Therefore, short-sellers cannot directly use the proceeds from short selling to reinvest or to hedge their short position. Fifth, the standard stock-lending practice is that the loan must be paid on demand, i.e., the short-seller also faces a "squeeze" risk (Dechow, Hutton, Meulbroek, and Sloan, 2001).

I summarize motives for short selling into the following four hypotheses:

1. Trend Hypothesis: Some investors are trend-traders, i.e., they will buy the stocks if the past short-term prices are increasing and sell or short stocks if the past short-term prices are de creasing. Short-sellers will close their position if the stock prices are increasing in past short-term. Jegadeesh and Titman (1993) show that there is a prices continuation over a three- to twelve-month horizon, and that the momentum strategies of buying winner and selling loser, can earn returns of around 1% per month. Ali and Trombley (2006) show that the magnitude of momentum returns is positively related to short-sale constraints and loser stocks, rather than winner stocks, drive the results. A negative relation between past short-term returns and the short-selling level is consistent with the behavior of momentum traders.