The Substitutability between Short Sales and Bearish-Option Activity

Abstract

Prior research argues that pessimistic traders can use options as substitutes for short sales particularly when stocks are expensive to short. We test this hypothesis and find that (i) put-call ratios are inversely related, instead of directly related, to proxies for short-sale constraints and (ii) the significant negative relation between current put-call ratios and future returns (Pan and Poteshman, 2006) is orthogonal to proxies for short-sale constraints. These results indicate that short-sale constraints do not influence bearish option activity. While prior studies show that short sellers are generally contrarian in contemporaneous and past returns, we find that put-call ratios follow periods of negative returns. However, any observed return predictability contained in put-call ratios is driven by ratios that follow periods of positive returns.