Short selling

In finance, a short selling (also known as a short, short sale, shorting, or going short) is the sale of an asset (securities or other financial instrument) that the seller does not own. The seller affects such a sale by borrowing the asset in order to deliver it to the buyer. Subsequently, the resulting short position is “covered” when the seller repurchases the asset in a market transaction and delivers the purchased asset to the lender to replace the quantity initially borrowed. In the event of an interim price decline, the short seller will profit, since the cost of (re)purchase will be less than the proceeds received upon the initial (short) sale. Conversely, the short position will result in a loss if the price of a shorted instrument rises prior to repurchase.

Market participants short sell for various reasons. Specialists on the exchanges, market makers, and block traders sell short to provide market liquidity. Arbitrageurs short sell to realize profits on temporary price disparities in markets or like securities. Institutions, money managers and individuals sell short to speculate on price declines. Firms that are usually shorted fall into three broad categories: 1) Companies in which management lies to investors and obscures events that will affect earnings; 2) companies that have largely inflated stock prices which suggest speculative bubble in company valuation; 3) companies that will be affected in a significant way by changing external events.

Majority of equity short selling strategies try to identify some sort of bad management practices in hiding true value of the firm. Overvalued firm can be identified by looking at trends of rapid price declines of equities and prior events or developments that could had potentially caused it. Jensen(2005) developed a model for ex ante identifying firms with overvalued equity. The model combines an assessment of financial statements fraud with fundamental analysis – characteristics of the firm’s operating, investing and financing activities that suggest value destroying managerial behaviour. Beneish and Nichols (2009) develop a profile of overvalued equity, and show that firms meeting this profile experience abnormal stock returns net of transaction costs of -22 to -25 percent over the twelve months following portfolio formation. Their model is based on Overvaluation score that score the following factors: likelihood of earnings overstatement (based on the Beneish (1999)’s PROBM measure), high sales growth, low operating cash flows to total assets, an acquisition in the last five years, and unusual amounts of equity issuance in the past two years.

Window-dressing is a common folly of managers who want to increase their portfolio price above its true value. Identifying this behaviour lads short seller to discovery of an overvalues stock that has historically been good candidate for short selling. The Turn of the month effect (TOM) has been documented in a number of different research papers and articles. A number of calendar / seasonality anomalies were identified in Josef & Smidt, 1988 that found number of persistent (or semi-persistent) anomalies. Other researchers have found (Lakonishok, Shleifer, Thaler, & Vishny, 1991) that there is persistent pressure on fund managers to only display “good stocks” in (mainly quarterly) client reports. According to the authors, this leads to selling pressure into the month-end, effectively cleaning up the book from any bad bets. Nilsson (2015) finds that there is a meaningful negative expected return from owning equities in the last trading hour of the month. The effect is large and potentially exploitable by investors that are not tied to monthly reporting cycles. Using this fact an investor can short S&P futures for one hour (from 3pm EST until 4pm EST) during one day (last trading day of the month) and then covers position.

Short selling is still a non-traditional way of making money from the markets and carries costs and risks. Due to this reason it is believed that only well informed trader such as a corporate insider would endeavour to short sell. Chung, Sunl and Wang (2018) propose a strategy that utilizes trading information of both short sellers and corporate insiders. They find that the strategy earns statistically significant and economically meaningful risk-adjusted returns for at least one year, which stems mainly from the information asymmetry between informed and uninformed investors.

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The Encyclopedia of Quantitative Trading Strategies

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