Binding Short-sale Constraints Research Articles

Alpha by Affiliation

Using novel data establishing hedge fund families, we show that changes in overlapping hedge fund family positions predict abnormal returns in U.S. stocks. A long-short portfolio of unanimous family entries and exits in overlapping positions earns an annualized alpha of 7.32%. Panel regressions and double-sorts provide evidence for a mispricing-based explanation as results are consistent with fund families facing binding short sale constraints to coordinated exits. The returns are larger for high information asymmetry stocks and suggest that hedge fund families coordinate on information, despite having no shared legal structure like mutual fund families.

Testing Disagreement Models

We provide plausibly identified evidence for the role of investor disagreement in asset pricing. Our natural experiment exploits the staggered implementation of EDGAR, which induces a reduction in investor disagreement with no accompanying changes in company fundamentals, disclosure quality, or earnings management. The reduction in disagreement leads to lower stock price crash risk. The effect is more pronounced for stocks with binding short-sale constraints and high investor optimism. The reduction in disagreement also leads to higher subsequent returns. Our results provide evidence consistent with models of investor disagreement.

Dispersion in beliefs among active mutual funds and the cross-section of stock returns

We propose a measure of dispersion in fund managers׳ beliefs about future stock returns based on their active holdings, i.e., deviations from benchmarks. We find that both the level of and the change in dispersion positively predict subsequent stock returns on a risk-adjusted basis. This effect is particularly pronounced among stocks with high information asymmetry and binding short-sale constraints. These results suggest that a subgroup of informed managers drives up the dispersion in active holdings when they place large bets after receiving positive private information. Binding short-sale constraints, however, prevent them from fully using their negative private information, leading to low dispersion in active holdings.

Short-sale constraints and the idiosyncratic volatility puzzle: An event study approach

Abstract Using three natural experiments, we test the hypothesis that investor overconfidence produces overpricing of high idiosyncratic volatility stocks in the presence of binding short-sale constraints. We study three events: IPO lockup expirations, option introductions, and the 2008 short-sale ban on financial firms. Consistent with our prediction, we show that when short-sale constraints are relaxed, event stocks with high idiosyncratic volatility tend to experience greater price reductions, as well as larger increases in trading volume and short interest, than those with low idiosyncratic volatility. These results hold when we benchmark event stocks with non-event stocks with comparable idiosyncratic volatility. Overall, our findings suggest that biased investor beliefs and binding short-sale constraints contribute to idiosyncratic volatility overpricing.

Earnings Announcements, Differences of Opinion and Management Guidance

AbstractBerkman, Dimitrov, Jain, Koch, and Tice (2009) document a negative relationship between differences of opinion and earnings announcement returns, and this relationship is more pronounced when short‐sale constraints are likely to be high. These findings are interpreted as support for the theory in Miller (1977) that binding short sale constraints cause pessimists to be underrepresented in price formation. We conjecture that accounting information (i.e., earnings news) is likely to play a role in this returns pattern. After controlling for the level of earnings news, we find that the relationship between differences of opinion and stock returns is either eliminated or opposite from what is predicted by Miller's theory. Further, we present evidence that suggests the confounding effect of earnings news can be explained by (pessimistic) management earnings guidance. Our findings offer an alternative explanation for why low differences of opinion stocks earn greater abnormal returns around earnings announcements.

Comparing the information in short sales and put options

Prior work shows that both short sales and put options contain information about future stock prices. In this study, we compare the return predictability in short sales to the return predictability in put options. The motivation for this comparison is based on the theoretical argument that informed traders can choose between short sales and put options when establishing short positions in a particular stocks. Results in this paper suggest that the underperformance of stocks with high short-selling activity is approximately four times larger than the underperformance of stocks with high put-option activity. While stocks that are most likely to face binding short-sale constraints drive the underperformance caused by put-option activity, we still find that short sales are generally more informative about future prices.

Offsetting Disagreement and Security Prices

We propose that investors are generally less excited about portfolios than they are about the individual companies in those portfolios. The reason is that companies liked by some investors are often not liked by other investors. This makes it almost impossible to construct a portfolio that perfectly pleases large groups of investors and contains (only) every investor's most favorite companies. The maximum level of excitement that a portfolio of companies receives from investors, therefore, is almost always less than the sum of the level of excitement that the individual companies in the portfolio receive from their most fervent supporters. In the presence of binding short-sale constraints, wherein prices are set by the most optimistic investors, this difference in the level of excitement can become priced. Utilizing closed-end funds, exchange-traded funds, mergers and acquisitions, and conglomerates in which the value of the aggregate portfolio and the values of the underlying components can be separately evaluated, we present evidence supporting our proposition.

Dispersion in Beliefs among Active Mutual Funds and the Cross-Section of Stock Returns

We propose a measure of dispersion in fund managers’beliefs about future stock returns based on their active holdings, i.e., deviations from benchmarks. We find that both the level of and the change in dispersion positively predict subsequent stock returns on a riskadjusted basis. This effect is particularly pronounced among stocks with high information asymmetry and binding short-sale constraints. These results suggest that a subgroup of informed managers drive up the dispersion in active holdings when they place large bets after receiving positive private information. Binding short-sale constraints, however, prevent them from fully using their negative private information, leading to low dispersion in active holdings. JEL classification: G10, G11, G12, G14

Short Sales, Stealth Trading, and the Suspension of the Uptick Rule

Boehmer, Jones, and Zhang (2008a JF) show that informed short sellers do not stealth trade and hypothesize that because short sellers face execution uncertainty caused by the uptick rule, informed short sellers cannot afford to break up their larger trades into smaller trades in order to hide their information. This paper tests whether short sellers’ propensity to stealth trade is related to the presence of the uptick rule. Contrary to the hypothesis in Boehmer, Jones, and Zhang (2008a), we show that the distribution of information contained in short sales shifts to larger trade sizes, rather than to smaller trade sizes, after the suspension of the uptick rule. We also show that the increase in information contained in large short sales during the post-suspension period is driven by stocks that are most likely to face binding short-sale constraints. Combined, results in this study suggest that the use of larger trade sizes by informed short sellers is affected more by equity borrowing constraints than by regulatory constraints such as the uptick rule.

Earnings Announcements, Short Sale Constraints, and Management Guidance

Berkman, Dimitrov, Jain, Koch, and Tice (2009) document a negative relation between differences of opinion and earnings announcement returns, and this relation is more pronounced when short sale constraints are likely to be high. These findings are interpreted as support for the theory in Miller (1977) that binding short sale constraints cause pessimists to be underrepresented in price formation. We conjecture that accounting information (i.e., earnings news) likely plays a role in this returns pattern. After controlling for the level of earnings news, we find that the relation between differences of opinion and stock returns is either eliminated or opposite from what is predicted from Miller’s theory. Further, we present evidence that suggests the confounding effect of earnings news can be explained by (pessimistic) management earnings guidance. Our findings offer an alternative explanation for why low differences of opinion stocks earn greater abnormal returns around earnings announcements.

Extrapolation Bias vs. Overconfidence: When Short Sale Constraints are Binding

This paper combines the market friction and traders’ behavioural biases and explicitly sets up the scenario for short sale constraints are binding. The paper contributes to the literatures by comparing the differences of extrapolation bias and overconfidence’s impacts upon asset price, market liquidity and volatility when short sale constraints are binding. The results indicate that binding short sale constraints would lead to overvaluation, the extrapolation bias’ impact upon this overvaluation is exogenous and market state-dependent: it would aggravate the overvaluation in bull market and mitigate it in bearish market, and the magnitude of the impact positively depends on the direction and extent of extrapolation bias and the proportion of the informed traders with extrapolation bias who are non-binding by short sale constraints. However, the confidence’ impact upon the overvaluation is endogenous, and the more confident informed traders enter the market or the larger degree they overestimate the received private signal would both mitigate the overvaluation. Furthermore, when short sale constraints are binding, contrary to the case that extrapolation bias does not affect market liquidity and volatility, confidence would decrease market liquidity and increase market volatility if the precision of public information is above a certain threshold.

Market Migration: Informed Short Sales and Option Introductions

This study tests the hypothesis that informed shorting activity decreases in the stock market when options become available because informed traders migrate from the stock market to the options market after options are introduced. To the contrary, we do not find that shorting activity decreases. Instead shorting activity increases after options list. Furthermore, we show that the common negative relation between current short selling and future returns becomes stronger after options are introduced. This result appears to be driven by stocks that are most likely to face binding short-sale constraints. Contrary to the idea that informed traders migrate to the options market, findings in this paper indicate that informed short selling increases after options become available.

Comparing the Information in Short Sales and Put Options

Prior work shows that both short sales and put options contain information about future stock prices. In this study, we compare the return predictability in short sales to the return predictability in put options. The motivation for this comparison is based on the theoretical argument that informed traders can choose between short sales and put options when establishing short positions in a particular stocks. Results in this paper suggest that the underperformance of stocks with high short-selling activity is approximately four times larger than the underperformance of stocks with high put-option activity. While stocks that are most likely to face binding short-sale constraints drive the underperformance caused by put-option activity, we still find that short sale are generally more informative about future prices.

Short Sales and Option Listing Decisions

This study tests the hypothesis that exchanges choose to list options for stocks that experience high levels of short activity. Results show that short activity is markedly higher for stocks that list options than for stocks that are eligible but do not list during the month prior to the option introduction. This result holds when controlling for other know determinants of the listing decision. The abnormal pre-listing short activity is driven by stocks that are most likely to face binding short-sale constraints indicating that exchanges not only look at short activity but short activity in stocks that are costly to short. Our final set of tests examines post-listing option volume and shows that option volume is increasing in the level of pre-listing short activity. Interestingly, when controlling for short activity, some of the other known determinants become orthogonal to post-listing option volume.

Short-Sale Constraints and the Idiosyncratic Volatility Puzzle: An Event Study Approach

Using three natural experiments, we test the hypothesis that investor overconfidence produces overpricing of high idiosyncratic volatility stocks in the presence of binding short-sale constraints. We study three events: IPO lockup expirations, option introductions, and the 2008 short-sale ban on financial firms. Consistent with our prediction, we show that when short-sale constraints are relaxed, event stocks with high idiosyncratic volatility tend to experience greater price reductions, as well as larger increases in trading volume and short interest, than those with low idiosyncratic volatility. These results hold when we benchmark event stocks with non-event stocks with comparable idiosyncratic volatility. Overall, our findings suggest that biased investor beliefs and binding short-sale constraints contribute to idiosyncratic volatility overpricing.

Short Sale Constraints, Dispersion of Opinions, and Overnight Returns

Using nine years of data for the largest 3,000 U.S. stocks, we find a tendency for positive returns during the overnight non-trading period followed by reversals during the subsequent trading day session. This pattern is driven by an opening price that is high relative to intraday prices, rather than by a closing price that is low, suggesting that an overnight liquidity premium cannot be the sole cause of this price regularity. Instead, consistent with Miller's (1977) theory applied to the overnight period, we find this behavior is more prevalent among stocks that are more overpriced - with more binding short sale constraints and higher dispersion of opinions. Such overpriced stocks have a higher opening price, and a concomitant tendency for larger overnight returns and trading day reversals.

Short Sale Constraints, Overvaluation, and the Introduction of Options

We investigate whether the existence of traded options represents an economically important relaxation of short sale constraints. Our analysis has three prongs. First, to the extent that option listing relaxes a binding constraint, we would expect to see investors taking synthetic short positions in the newly-listed options. Contrary to this hypothesis, we find that the volume of newly-listed options tends to be very low, and, if anything, signed volume is more bullish that bearish during the first week of trading. Moreover, we find no significant relation between signed option volume and abnormal stock returns surrounding option listing. Second, if options help relax binding short-sale constraints, we might expect bearish option volume to be positively related to proxies for short sale constraints, divergence of opinion, and/or overvaluation. We examine nine different proxies and combinations of proxies, and in each case find either no relation, or a significant negative relation. Third, we demonstrate that prior results in the literature reporting a negative price reaction surrounding option listing are not robust to alternative methodological assumptions. All our evidence suggests that options do not reduce short sale constraints in an economically meaningful way.