Handbook of Finance: Financial Markets and Instruments

Chapter 12. The Information Content of Short Sales

STEVEN L. JONES, PhD

Associate Professor of Finance, Indiana University, Kelley School of Business–Indianapolis

GLEN LARSEN, Jr., PhD, CFA

Professor of Finance, Indiana University, Kelley School of Business–Indianapolis

Abstract: Short interest in a stock is the aggregate number of shares that have been sold short and not yet covered. There has been a long-running debate over whether short interest contains valuable information about a stock's future performance. Weak-form market efficiency suggests that competitive trading should erode any information content in the signal. However, Wall Street analysts have traditionally viewed high short interest as a bullish technical indicator since covering short positions creates upward price pressure and recalls and short squeezes may force premature coverage of short positions. Alternatively, academic studies find that short-sale constraints clearly result in overpricing and that high short interest predicts negative future returns, consistent with the theories developed by Edward Miller in 1977 and Douglas Diamond and Robert Verrecchia in 1987, respectively. Miller's theory of divergent opinions predicts that short-sale constraints lead to overpricing, while Diamond and Verrecchia's theory predict that an unexpected increase in short interest is bad news since it indicates a higher proportion of past sales, than previously realized, came from the presumably more-informed short sellers. Thus, ...