Do Short Selling and Margin Trading Affect Price Randomness?

Abstract

Purpose: Both short sellers and margin traders believe in active investment. However, they have the opposite opinions about the prediction of future share price direction: while short sellers are those who predict future price declines, investors buying on margin are those who predict future share price increases. Short selling and margin trading are generally perceived to intensify stock price volatility and undermine market stability. However, this general perception in investment practice lacks in scientific empirical evidence. This paper investigates the effect of short selling and margin trading on stock price randomness in Korean stock market. Design/methodology/approach: The random walk hypothesis has been tested for many equity markets since Lo and MacKinley (1988) work, which proposes the variance ratio test for the random walk hypothesis. The Dickey-Fuller unit root test or the Box-Pierce Q test are widely used to test the stock price efficiency. However, Lo and MacKinley (1989) indicate that the variance ratio test is more reliable and more powerful than the two tests. Ayadi and Pyun (1994) also acknowledge that the variance ratio test is more appealing than other traditional tests for the random walk. Findings: Our main findings are as follows. Short selling increases variance ratios, suggesting that short selling decreases the degree of price randomness. However, margin trading is negatively related to variance ratios. Short selling makes stock prices more predictable; on the contrary, margin trading makes stock prices more random. Dividing by market, short selling and margin trading is more active in the KOSPI market than the KOSDAQ market. The variance ratio test shows that short selling in KOSPI market exacerbates price randomness compared to KOSDAQ market. We also find that a significant and positive relation between short selling and absolute deviation of the variance ratio when short selling is constrained. Research limitations/implications: Our study tried to provide new implications to both practitioners and academicians by analyzing the effects of short selling and margin trading on price randomness, a major aspect of market efficiency. However, this study still has some limitations in that the effect of short selling and margin trading on market efficiency has not been completely fully analyzed. Therefore, we expect that further studies on the effects of short selling and margin trading on market efficiency will be conducted to provide additional implications. Originality/value: Our study uses the same data in analyzing the impact of short selling and margin trading. Thus, compared to two separate strands of studies on short selling and margin trading, our study would facilitate the comparison of the empirical results on the impact of these two investment methods. Analyzing and comparing the effects of two investment methods on the same data would enhance the reliability of the comparative empirical results.