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Constrained Short Selling and the Probability of Informed Trade

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Constrained Short Selling and the Probability of Informed Trade Tyler R. Henry† University of Washington This Draft: January 2005 Abstract This paper considers the effect of private information on the returns to stocks with high levels of short interest. Using a structural trade model from the market microstructure literature, I model the impact of short selling constraints on the probability of information based trade (PIN). The model shows that PIN increases as the constraint on informed short selling is lowered. Empirically, I estimate PIN for a sample of high short interest stocks and form monthly portfolios based on PIN. After controlling for size, book-to-market, and momentum, I find that high PIN portfolios generally produce negative abnormal returns, while low PIN portfolios do not. The results support three main conclusions. First, some stocks with high levels of short interest do underperform. Second, the underperformance of high short interest stocks may be better explained by the probability of informed trading rather than by short interest levels alone. Finally, if PIN is a valid proxy for informed trading, then asymmetric information models offer new insights for the returns to high short interest stocks. I would like to thank my committee members for discussions and guidance, including Jennifer Koski (Chair), Jonathan Karpoff, Ed Rice, and Lance Young. I also appreciate the valuable comments of Bart Danielsen, Wayne Ferson, Jaehoon Hahn, Andrew Karolyi, and seminar participants at the University of Washington, the 2004 FMA Annual Meetings, and the 2004 FMA Doctoral Consortium. I am responsible for any remaining errors. † Ph.D. Student, Department of Finance and Business Economics, University of Washington, Box 353200, Seattle, WA 98195-3200. Email: [email protected]. I. Introduction This paper offers a new approach to assess the information content of short interest by examining the relationship between informed trading and the returns to high short interest stocks.1 I use a measure of the probability of informed trading derived from a microstructure trade model [Easley, Kiefer, and O’Hara (1997b)] to help explain underperformance in stocks with high levels of short interest. I find that this measure is successful at predicting underperformance in highly shorted firms. In general, the results indicate that the underperformance of high short interest stocks may be limited to stocks with high levels of informed trading. Thus, a full understanding of the returns to these stocks may require the consideration of information asymmetries. This result is not surprising given both informed and uninformed motivations for short selling. This work contributes to two areas of the literature. First, it adds to the literature examining the information content of short interest. Traditionally, this line of research tests the relationship between the level of short interest in a stock and its future returns. Theory implies that short interest may be a negative information signal. Diamond and Verrecchia (1987) show that short selling is more likely to be carried out by informed traders with negative information due to the high costs associated with short sales. Figlewski (1981) argues that the actual level of short interest is a proxy for the unfulfilled demand to short sell, and therefore represents the amount of adverse information excluded from the market. The empirical prediction that emerges from these arguments is that stocks with high short interest will have low subsequent returns. Yet, the empirical results in this area have been mixed. Early papers did not find a strong or consistent relationship between short interest and subsequent returns, and claimed that a considerable amount of short selling was arbitrage or hedging related [Brent, Morse, and Stice (1990), Figlewski and Webb (1993), Senchack and Starks (1993), Woolridge and Dickinson (1994)]. Such trades are not motivated by information and should not have predictive power for future returns. Later papers found that stocks with high levels of short interest generate subsequent negative abnormal returns, and argued that short sellers do have information [Asquith 1 Short interest is the number of outstanding short positions for an individual stock. Short interest figures are collected by the stock exchanges and released to the public on a monthly basis. All references to short interest levels in this paper refer to the short interest ratio, which is the number of short positions divided by the number of shares outstanding. Further details are contained in Section IV. and Meulbroek (1996), Gintschel (2001), Desai et al. (2002)]. Recently, Asquith, Pathak, and Ritter (2004) have questioned the robustness of these findings. The approach in these recent papers is to form monthly portfolios based on the level of short interest in a stock and test for subsequent underperformance. Following Figlewski’s (1981) assumption that short interest is a proxy for negative information, they posit that negative abnormal returns should be increasing in the level of short interest. There are two concerns with this assumption. First, as pointed out by D’Avolio (2002) and Chen, Hong, and Stein (2002), variations in short interest levels across stocks could reflect differences in the transaction costs of short selling rather than differences in information. Secondly, this assumption disregards the role of short selling related to uninformed trading strategies. The second issue is where this paper offers additional guidance. Specifically, the contribution of this paper is to more finely characterize which high short interest stocks should have low subsequent returns. Because some short selling may be informed while some may be related to uninformed arbitrage or hedging strategies, the link between the level of short interest and the level of informed trading is uncertain. High levels of short interest may or may not be indicative of high levels of information. Accordingly, the short interest level for a stock is a noisy information signal. However, any information contained in high short interest levels is, presumably, negative. In other words, high short interest indicates the direction of information, conditional on the existence of information. Consequently, those high short interest stocks for which information exists should be the ones with greater underperformance. Identifying stocks with higher levels of informed trading may increase the precision of the information signal contained in short interest levels. For example, although Senchack and Starks (1993) find a weak relation between short interest and returns, they point out that an inability to purge noninformational short sales from the short interest numbers may confound any empirical tests, and remark that “the observed market reaction to short interest announcements may be underestimated due to noninformational short sales…” (p.186). Therefore, I borrow a measure from the market microstructure literature that identifies the level of informed trading in a stock. I use this measure, the probability of informed trading (PIN), to form portfolios in an effort to better forecast future underperformance. Thus, instead of testing the impact of short interest on future returns, I test the impact of PIN on future returns for a sample of stocks with high short interest. 2 Along these lines, this paper also contributes to the literature on microstructure models of asymmetric information. In a series of papers, Easley et al. (1996, 1997a, 1997b, 1998) develop a trade based measure of asymmetric information risk (PIN) and examine its empirical applications in a variety of contexts.2 If short sellers are informed, their presence in the market increases adverse selection costs for uninformed traders and the market maker. Their influence will be particularly relevant if the population of short sellers is, on average, more informed than the population of regular sellers or buyers. To address this issue, this paper considers the effect of short sale constraints on levels of information asymmetry. Because constraints affect informed and uninformed traders differently, these constraints have implications for the probability of informed trading. Furthermore, since I am interested in the returns to stocks with high amounts of short selling, the impact of these constraints on PIN may be important. In general, this paper unites these two distinct literatures. The approach is to reframe the short interest tests into an asymmetric information context. The objective is to determine if the signal content of short interest levels is improved when controlling for the probability of information based trade. I begin with a sequential trade model that is used to derive the empirical measure for the probability of informed trading [Easley, Kiefer and O’Hara (1997b)]. I extend this model to demonstrate how constraints placed on short selling will affect this probability. I find that as the fraction of informed traders who are constrained is lowered, the probability of informed trading increases. Under these conditions, the likelihood that short selling originates from informed traders is higher. The result is a link between informed short selling and the probability of informed trade. Thus, I use PIN to proxy for the amount of informed trading in an effort to identify stocks with informed short selling. Those stocks with higher amounts of informed short selling should have a stronger relation with future returns. Namely, I hypothesize that stocks
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