Short Selling Basics-In Stock Market


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“The barometer of stock market” –

The material researched from the book -By William Peter Hamilton

6 Important Features of Short Selling:

  1.  Data Shows: overall,1 of every 42 trades involves a short sale.
  2. Short selling is more common among stocks with high returns than stocks with weaker performance
  3. Actively traded stocks experience more short sales than stocks of limited trading volume
  4.  Short selling does not appear to be systematically different on various days of the week.
  5. Days of high short selling precede days of unusually low returns.
  6. Short selling varies directly with share price volatility.

Understanding frequency of short selling

Two complementary metrics: First calculate two things about the stock:  

  • Short sell shares/Total shares = Percentage of shorted shares – Which is the ratio of the shares in the short trades to the total number of a company’s shares traded in the day. This percentage concerns the probability that a traded share is being shorted. 
  • Short sell trades/Total trades=Percentage of short trades – (The “percentage of short trades,” which is the ratio of short trades to the total number of trades in a stock within a day. This percentage addresses the likelihood that the seller in a transaction is shorting)

What these ratios will tell You:

  1. These results indicate that short sellers tend to transact in larger volume than the typical non shorting investor

  2. Study found that, on average, the seller in 1 of every 42 trades is shorting and that 1 of every 35 traded shares is a shorted share.

  3. These results indicate that short sellers tend to transact in larger volume than the typical nonsporting investor.

Short sellers tend to follow a contrarian strategy-  Inclined to stocks with the highest returns

 The second issue Study examined is whether short selling varies with a stock’s price performance in a manner that is consistent with either a momentum or contrarian investing style.

After partitioning the sample into quintiles based on the within-sample percentage change in the stock’s price, Study found that both the percentage of short trades and the percentage of shorted shares were highest for the quintiles containing the stocks with the highest returns and lowest for those with the lowest returns

 These results are most consistent with the proposition that short sellers tend to follow a contrarian strategy.

The link between short selling and trading volume:

 The liquidity offered by high-volume stocks potentially reduces the probability that the short seller will experience a “short squeeze” (when the shares that have been lent to the investor for the short sale are recalled).

 After partitioning the sample according to trading volume, we found that both the percentage of short trades and the percentage of shorted shares declined monotonically with trading volume. Therefore, as hypothesized, short sellers tend to be more interested in high-volume stocks.

Short selling and stock Price volatility:

 Examined the relationship between short selling and stock price volatility. Specifically, Study searched for any contemporaneous connection between the two:

 After partitioning the sample into quintiles according to the standard deviation of within-sample stock return, we found that short selling is highest for the most volatile stocks and lowest for low-volatility stocks.

Final Thoughts

 A number of prior studies documented a trend in which returns on certain days of the week tend to be significantly lower than returns on other days. Therefore, we considered whether any such day-of-the-week pattern is to be found in short selling. Somewhat surprisingly, our results indicate little day-to-day variation in short selling.

 Finally, Study examined the potential short-term profitability of short selling by examining market- adjusted returns following days of significantly high short selling. We found statistically significant three-day excess returns of −1.23 percent following days of high short selling, implying that an investor who opens a short position on a day of high short selling in a stock and closes it three days later can obtain a positive net profit. 

You can find the detail presentation on the topic in link.

SHORT SELLING

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