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Short Sellers: Contrarian or Momentum Traders?

| | Posted in: Short Selling

In the July 2005 update of their paper entitled “Can Short-sellers Predict Returns? Daily Evidence”, Karl Diether, Kuan-Hui Lee and Ingrid Werner examine recently available daily short sales data to test whether short-sellers trade with or against the trend and whether they can predict future returns. Using the SEC-mandated tick-by-tick short-sale data for 2,815 Nasdaq-listed stocks from the first quarter of 2005, they find that:

  • During the period examined, short sales represented about 25% of total Nasdaq volume with only a fourth of this activity from options and equity market makers (exempt from short-sale rules). Since monthly short interest for the same period is only 3.3% of shares outstanding, most short-selling must be short-term, perhaps intraday.
  • Short-sellers are on average contrarian. They decrease their short-selling activity following negative abnormal returns and increase their short-selling activity following positive abnormal returns. However, a a significant fraction of retail traders are likely momentum traders.
  • Stock prices decline significantly the day following increased short-selling activity and significantly thereafter up to day three. Small trades are most predictive of future returns.
  • A trading strategy based on daily short-selling activity generates significant returns, but incurs costs large enough to wipe out any profits. A long-short trading strategy based on daily small-sized shorting activity quintiles generates a monthly positive abnormal return of 3.9%. Overall short-selling activity generates significant positive abnormal returns for small-cap stocks, stocks with low institutional ownership and stocks with no put options.
  • Appearance on the Regulation SHO threshold list suppresses subsequent short selling, but it does not significantly affect future returns for stocks priced $5.00 and above. However, stocks on the threshold list priced below $5.00 do have significantly lower future returns.
  • There is no evidence that current short sellers have private information about future earnings surprises.

In summary, very recent data suggests that short sellers on average are contrarians who predict (or trigger?) near-term stock price underperformance. However, the underperformance is economically insignificant due to transaction and carrying costs.

The authors note that this study is based on a sample limited in duration and scope.

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