Short Sellers, News, and Information Processing

The following post comes to us from Joseph Engelberg of the Department of Finance at UC San Diego, Adam Reed of the Department of Finance at the University of North Carolina, and Matthew Ringgenberg of the Department of Finance at Washington University in St. Louis.

There is strong evidence that high levels of short selling are associated with lower future returns and this return predictability suggests that short sellers, on average, have an information advantage over other traders (e.g., Senchack and Starks, 1993; Asquith, Pathak, and Ritter, 2005; Boehmer, Jones, and Zhang, 2008). However, while return predictability suggests that short sellers have an information advantage, it says little about the source of this advantage. In our forthcoming Journal of Financial Economics paper, How Are Shorts Informed? Short Sellers, News, and Information Processing, we ask how short sellers obtain an information advantage.

During the financial crisis in 2008, some regulators and journalists accused short sellers of illegitimate trading practices. In fact, the Securities and Exchange Commission (SEC) suggested that short sellers spread “false rumors” in an effort to manipulate firms “uniquely vulnerable to panic.” However, in contrast to this manipulation hypothesis, we find that a substantial portion of short sellers’ trading advantage comes from their ability to analyze publicly available information. These findings suggest that, on average, short sellers do not manipulate prices, but rather, they help prices incorporate pertinent information.

To examine the source of short sellers’ trading advantage, we combine a large database of corporate news articles with a large panel of daily short selling data. This unique combination allows us to comprehensively examine the relation between short selling and public news events. Existing theoretical models provide mixed predictions on the relation between news events and financial markets. On the one hand, a number of papers argue that news reduces information asymmetries (e.g., Korajczyk, Lucas, and McDonald, 1991; Diamond and Verrecchia, 1987). On the other hand, several papers suggest that public news events can lead to differential interpretations by traders based on variation in traders’ skill (e.g., Kandel and Pearson, 1995). Rubinstein (1993) puts it succinctly: “In real life, differences in consumer behavior are often attributed to varying intelligence and ability to process information. Agents reading the same morning newspapers with the same stock price lists will interpret the information differently.” Consistent with the latter view, we find that public news events appear to be precisely the moment when informed traders gain an information advantage over others.

While news events occur on only 22% of the days in our sample, we find that short positions initiated on these days account for over 45% of the total profitability from short selling. Thus, while there is evidence that some short sellers trade prior to certain events, (e.g., Karpoff and Lou (2010), Christophe, Ferri, and Angel (2004)), we find that a substantial portion of short sellers’ trading advantage comes from their ability to analyze publicly released information. We also find that the relation between short sales and future returns is significantly stronger following bad news. However, when we examine news articles which contain neither good nor bad information (and so the potential advantage from processing information is likely minimal), we find that the relation between short sales and returns is significantly weaker. Finally, when we examine the trades of market makers separately from the trades of other short sellers, we find that the most informed short sales are not from market makers but rather from clients. The results are consistent with the idea that public news provides valuable trading opportunities for short sellers who are skilled information processors.

Overall, our findings shed light on the evolution of informed traders in financial markets. Although many models of financial markets assume the existence of informed traders who have superior information about asset values, these models often beg the question: where do these informed traders come from? Because short sellers are well known to be informed traders, we can think of the environment in our study as a laboratory for informed trading in general. From this perspective our paper addresses a more fundamental question: how do informed traders become informed?

The answer in our study is perhaps surprising. Instead of leveling the information playing field between informed and uninformed traders, news events appear to actually increase information asymmetries. Our results suggest that short sellers tend to be skilled information processors who help prices incorporate pertinent information. Accordingly, the findings have important implications for academics, practitioners, and regulators seeking to understand the role that short sellers play in financial markets.

The full paper is available for download here.

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