What Makes Shorts Throw in the Towel?

In their February 2005 paper entitled “Holding on to Your Shorts: When do Short Sellers Retreat?”, Pavel Savor and Mario Gamboa-Cavazos examine NASDAQ trades during the period June 1988 through August 2001 to determine the circumstances in which short sellers choose to increase their common stock positions and those in which they choose to cover. They focus on stocks unlikely to have unusual short sale constraints.The authors find that:

• Between 1988 and 2001, the short interest for the median stock jumps about six-fold, probably due a combination of increased demand for shorting (by hedge funds) and increased supply of shares available for borrowing (from institutions).
• Valuation-motivated short sellers cover their positions after suffering losses, and increase them after experiencing gains. This result holds for 1988-1994 and 1995-2001 subsets of the data. Arbitrage-motivated short sellers tend not to alter their positions after suffering losses or experiencing gains.
• Stocks which produce gains for short sellers (by decreasing in price) tend to underperform the market significantly on a risk-adjusted basis over the next 30 to 250 trading days (by 1.2% and 7.3%, respectively). Stocks which produce losses for short sellers (by increasing in price) tend to underperform the market slightly on a risk-adjusted basis over the short term only.

In summary, short sellers throw in the towel (throw more punches) when stock prices move against (with) their positions.

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