We present empirical evidence that short sales contribute to market efficiency by increasing the speed of price adjustment to not only private/public firm-specific information but also market-wide information. Shortable stocks are characterized by weaker trade continuity and stronger quote reversals. They adjust faster to new information than non-shortable counterparts. These findings remain robust even in an “up” market condition in which short sales are not binding. The amount of information incorporated in each trade is also significantly higher for shortable than non-shortable stocks in both “up” and “down” market conditions. After controlling for firm size, trading volume, liquidity, price and option trading, short sales stand out as one of the significant factors that speed up the price adjustment.
A short sale is a trading strategy that capitalizes on anticipated declines in the price of a security. Shares are borrowed and sold in the open market and then bought back and returned at some point in the future. Short sellers profit if the share prices decline or incur losses if the prices rise. Both academicians and practitioners have long been interested in studying the benefits and costs of short sales. One of the major research focuses is the impact of short sales on price efficiency. In an efficient price discovery process, the price of a security should fully reflect all current and past information and should adjust to new information instantaneously (Fama, 1991). Short sales restrictions and prohibitions constrain investors from reacting to bad news but not good news, delaying the speed of price adjustment to negative information and causing an asymmetric price transmission process. Asymmetric price transmission refers to pricing phenomenon occurring when prices react to negative information in a different manner than positive information. Asymmetric price transmission has two angles, asymmetric magnitude of price changes and asymmetric speed of price adjustment. The majority of past studies focus on the former angle, especially the relation between short sales and stock overvaluation (Miller, 1977, Figlewski, 1981, Danielsen and Sorescu, 2001, Jones and Lamont, 2002, Ofek and Richardson, 2003 and Chang et al., 2007, among others).
This paper focuses on the latter angle, by measuring the speed of price adjustment to new information. We add at least four new contributions to the study of short sales: first, we examine the impact of short sales on the speed of price adjustment to both private/public firm-specific information and market-wide information.1 Second, we anatomize and contrast the price discovery processes of shortable and non-shortable stocks. We discover that shortable and non-shortable stocks differ in trade continuity, quote reversals, and incorporation of information in each trade. Third, we evaluate the speed of price adjustment both in “down” and “up” market conditions. The role of short sales has not been studied in the up market condition because it was considered not binding. Fourth, we compare the impact of short sales on the speed of price adjustment to new information while firm-specific characters, such as trading volume, firm size, liquidity, the availability of options, price level, etc., are controlled.
Our analyses yield the following results. First, shortable stocks need fewer trades and less time to adjust to new information than non-shortable stocks. Second, when a stock is shortable, its trade continuity is weaker, quote reversal is stronger, and the amount of information incorporated from each trade is larger than a non-shortable counterpart.2 Third, short sales speed up the price adjustment to not only private/public firm-level information but also market-wide information. Fourth, all of the results are robust in both up and down market. Fifth, short sale remain significant in enhancing the speed of price adjustment after controlling for the firm size, liquidity, trading volume and optioned status are controlled.
The rest of the paper is organized as follows: Section 2 examines the current literature on short sales; Section 3 introduces the institutional background and data; Section 4 tests the first hypotheses on the speed of price adjustment to the private/public firm-specific information content of each trade; Section 5 tests the second hypothesis on the speed of price adjustment to market-wide information; Section 6 presents the results of various robustness checks. In particular, we examine whether short sales play any role in an up market situation in which short sales are not binding. We also examine what happens to the speed of price adjustment for those stocks that are removed from the D-list. We also compare the speed of price adjustment of optioned and non-optioned stocks. We then compare the significance of short sale with other firm-specific characters, on enhancing the speed of price adjustment. Section 7 concludes the paper.
Taking advantage of the unique features afforded by the HKEx where only a designated group of stocks can be sold short and short interests are released daily, we measure the speed of price adjustment for the stocks before and after they join the D-list. Using trade-by-trade data, we investigate the speed of price adjustment to the information contained in each trade (including firm-specific private and public information) and to market-wide information for the stocks before and after they become shortable. Our major findings include: first, short sales speed up the price adjustment to not only firm-specific private/public but also market-wide information. Second, short sales speed up the price adjustment in not only down market but also up market days. Third, short sales enhance information efficiency by reducing trade continuity and increasing quote reversals. Additionally, shortable stocks incorporate more information in each trade. Hence, short sales significantly enhancing overall market efficiency. The costs of these benefits have yet to be investigated, which will be a future study in this topic area.
