Short Selling Reduces Crashes

Image result for coyote cliffShort sellers are often scapegoated for market crashes but a rational market requires rational buyers and sellers. When the markets are dominated by irrational exuberance only the short sellers are speaking sanity. Short-sellers, therefore, should make prices more informative and reduce the Wile E. Coyote moment when it suddenly dawns on the irrational that gravity exists.

Deng, Gao and Kim test the theory and find it holds up; lifting restrictions on short sales reduces prices crashes.

We examine the relation between short-sale constraints and stock price crash risk. To establish causality, we take advantage of a regulatory change from the Securities and Exchange Commission (SEC)’s Regulation SHO pilot program, which temporarily lifted short-sale constraints for randomly designated stocks. Using Regulation SHO as a natural experiment setting in which to apply a difference-in-differences research design, we find that the lifting of short-sale constraints leads to a significant decrease in stock price crash risk. We further investigate the possible underlying mechanisms through which short-sale constraints affect stock price crash risk. We provide evidence suggesting that lifting of short-sale constraints reduces crash risk by constraining managerial bad news hoarding and improving corporate investment efficiency. The results of our study shed new light on the cause of stock price crash risk as well as the roles that short sellers play in monitoring managerial disclosure strategies and real investment decisions.

Hat tip: Paul Kedrosky.


I once wrote a BBC piece comparing short sellers to carpenter ants.

In a good way.

BBC only means one thing around here - Big Black cock

Good comparison.

It has been officially revealed that the issue in the Amazon Forest is a drought period. In such periods, it rains little, and fires start. I wonder how foolish the people who slandered Brazilians must feel right now. It was Mother Nature all along.

To think the mainstream media has lied to us! The thought makes my blood boil.

See Ben Rhodes about the media:

1. "27 year olds whose experience is covering campaigns; they literally know nothing" (But are an extension of the DNC press office even when they're not bunking with administration officials).

2. The same people with the same properties, just 20 years older.

So that is the people tasked with the mission of informing America? Yet, Jefferson said, “if a nation expects to be ignorant and free, in a state of civilization, it expects what never was and never will be".

Yes, and 'evil speculators' anticipate shortages and promote price leveling in the long run. This is cutting edge research?

Yes, the arguments in favor of speculators and short-sellers are well-established, but how much empirical data is there showing the beneficial effects in action?

Indeed. I don't keep up with financial research so I don't know where the cutting edge is. The theoretical benefits of futures markets and speculation in general have been established for decades. I'd have to guess there's been plenty of empirical research but perhaps not on this specific topic of short sales, or perhaps not with a high quality data set.

So, unsurprisingly futures markets including short sales enhance the efficiency of markets under uncertainty. What about options though? They provide things -- namely choices, options -- that a mere futures market does not. Conversely, if short sales were not permitted, but options were permitted, could put options play the same useful role that short sales do?

Is it even possible to have the full panoply of options without the ability to do short selling? The writers of and the buyers of options often have to hedge the positions.

As I recall Shiller has been emphasizing this point for a really long time. One of the reasons he has been striving to securitize real estate is to enable short selling and stabilize prices.

In other news, J&J is responsible for the opioid crisis.

It's so simple. It's so hard. Markets crash when (relatively) there are no buyers.

Sell high (first); buy low (later) and deliver is a long-standing, sometimes profitable strategy.

Short sellers sell at (perceived) high prices (to later deliver at lower prices), and need to find sufficient numbers of longs/buyers willing to buy at those high prices. If the buyers are not there, there is minimal affect on market prices/moves.

It seems as if short selling became a liberal swear word circa 2008 when several guys realized that the housing market prices were inflated and approximately 30% of the underlying mortgages - generating cash flows to pay principle and interest on mortgage-backed securities - were sub-quality, i.e., more prone to default. They made several $ billion. They had (less prescient) buyers for their short sales.

They did not "tank" the market. The market "tanked" itself.

In other news, J&J is responsible for the opioid crisis.

Or, a lawyer in a suit is conspiring with a lawyer in a robe is conspiring to rape an industrial concern because, like the scorpion, that's what they do.

Question: are short sales always a bet on a share price decline?
I follow a thinly traded stock listed on an overseas exchange with short sales accounting for 50% of trading volume on some days. The share price is more likely than not to increase substantially within weeks.
I assume the rationale for the sales is hedging? (Or some shared price based incentive for an insider).

If short sales are used to hedge, does this "make prices more informative"? We can't know if the hedger is long 80%, short 20%.

Indeed, short sales are useful for hedging. I'd guess the difference between a short-sale for profit and a short-sale for hedging downside risk is that the former was done by someone who is very vocal about it, while only in rare occasions you hear/read about the later.

It's a bit like the joke about how to identify a vegan. A vegan will tell you about it today, later today, tomorrow, the day after tomorrow.......again and again until they die. Same for short-sellers ;)

That’s an old technical indicator. Since short sellers must purchase the stock, an increase in short selling indicates future demand for the stock. Of course, if the short sellers are correct, the price has declined before their purchases.

First, the article:

Crash risk is defined as large-scale decline in stock prices.

Then, "To empirically measure the intensity of management’s engagement in bad news hoarding and financial obfuscation for each firm in each sample year, we use the extent of accounting conservatism and opportunistic earnings management, captured by news-dependent, conditional conservatism measure of Khan and Watts (2009), denoted by C-Score and the accounting opaqueness measure of Hutton et al. (2009), denoted by ACCM, respectively."

Assuming the C-Score and ACCM are relevant metrics of what they intend to measure..."results suggest that the information asymmetry between controlling insiders and outside minority investors, arising from aggressive bad news hoarding and opportunistic earnings management, is an important channel through which short sale activities lead to lowering crash risk."

So, short-sellers: a) find out about bad news actively hidden by management, and b) discover shady accounting. Not bad, not bad at all.

Futures markets greatly reduce supply and price volatility. That lesson was learned in the modern era's first futures market, the Dojima Rice Exchange established in 1710 in Osaka, Japan. Indeed, Robert Shiller teaches his finance students that the futures market was the greatest innovation in finance. [In 1750 BCE, the sixth Babylonian king created one of the first codes, and it allowed sales of goods to be delivered in the future at an agreed price. In Aristotle's Politics, he tells the story of Thales, described as a philosopher, who engaged in futures trading in olives. He must have been an economist, because he relied on his own predictions of the future, in this case the harvest of the next autumn's olives.] That the authors of this study focus on misconduct by management (bad news hoarding) or malfeasance by management (inefficient investment) reflects just how cynical we have become about corporate behavior. A short seller might simply believe that shifts in supply or demand for a company's goods will adversely affect the company's future earnings and, hence, its stock price.

Nice to have folks confirming the obvious.

Indeed. You'll always have people denying the obvious and it's good to have data to push back with.

but but but we are a free market capitalist nation.... companies must be protected from stock price declines.

I am sympathetic to the Fed. It's not the Fed's fault that we have come to rely on rising asset prices for prosperity. What's the Fed to do, let asset prices fall and take the economy down with prices? To Trump's credit, he at least is open in his dishonesty about the Fed and what he wants the Fed to do, which is to support asset prices. Meanwhile, the monetarists babble on about money being too tight or too loose, about the need to target NGDP rather than inflation, about a futures market in NGDP, as though pushing on a string can make up for the savings glut and the reliance on rising asset prices for yield. I feel the Fed's pain.

Put not thy trust in central bankers . . . see Psalm 146:3.

How do you have prosperity without rising asset classes? Let's think this through. Prosperity means there's lot of stuff produced. Assets produced stuff. If an asset makes lots of stuff, errr, how could it not have a higher price? Wouldn't you expect a pizza oven that makes twice as many pizzas to have a higher price than one that makes less?

"which temporarily lifted short-sale constraints for randomly designated stocks."

I wonder if this really addresses general market crashes rather than crashes of individual stocks that are suffering a correction? I could see an argument that short-sell restrictions mean when a stock like, Enron, finally comes crashing down it crashes harder than it has too but at the same time a general market collapse like in 2008 short selling makes it worse and restrictions might make sense.

Short speculators are always criticized but longs never are...

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