The Tick Test Rule, Investors' Opinions Dispersion, and Stock Returns: The Daily Evidence on the NYSE

Abstract

This paper investigates the impact of short sale constraints on stock returns associated with the tick-test rule in the NYSE using REG SHO daily short selling data. The results suggest removing the tick-test rule for so called 'pilot' stocks mitigates short-term stock overvaluation by approximately 2% annually. It is surprising that for large pilot stocks, lifting the tick-test rule goes beyond correcting stock overvaluation and is associated with stock undervaluation, suggesting that the SEC's recent decision of removing tick-test restrictions for all U.S. exchange-traded securities may not be considered as an optimal policy if such undervaluation is driven by predatory short sellers' price manipulation. It also shows here that a high level of daily short sale activity signals a short-term stock return reversal during the sample period. On average, a daily rebalanced portfolio consisting of a long position in stocks with the highest shorting activities and a short position of stocks with the lowest shorting activities generates an annual rate of return of more than 150%, before adjusting for trading costs. The returns of these hedge portfolios are short lived; they diminish quickly as the number of days in the holding period increases.