Short sale constraints and the information content of trading

Abstract

We examine changes in the information content of trading when short sale constraints between prohibition and restriction exist on a stock exchange. This is made possible by a unique institutional arrangement at the Stock Exchange of Hong Kong. It maintains a list of stocks which can be sold short under regulations. Stocks not on the list are prohibited from short selling. The list is revised on a quarterly basis based on predetermined criteria. We find that the probability of information-based trading (PIN) significantly increases when a stock is added to the list. Further analysis shows that this is mainly because uninformed traders are driven out of the market. Elimination of uninformed traders also causes the aggregate trading volume to decrease rather than increase. In comparison, the PIN does not change when a stock is dropped from the list. We also find that market liquidity, measured by volatility and bid–ask spreads, slightly decreases when a stock is added to the list and significantly increases when a stock is dropped from the list. Possible explanations are discussed.