Supply and Demand Shifts in the Shorting Market by Lauren Cohen, Karl Diether, Christopher Malloy

Yet another interesting paper from the EFA Moscow Meetings!

SSRN-Supply and Demand Shifts in the Shorting Market by Lauren Cohen, Karl Diether, Christopher Malloy

Using a "proprietary database of lending activity from a large institutional investor" the authors examine

• Whether shorting impacts future returns?
• If shorting is important, is it "short supply" or "short demand"?
• Is shorting influenced by private? or public information?
• Is there a profitable trading rule that can be made off of shorts?
  

Their findings:

a. Demand for shorting stocks seems to be a good predictor of future returns.

b. As a predictor, demand is more important than supply. "...an increase in shorting demand leads to a significant negative average abnormal return of 2.54% in the following month. Decreases in shorting supply play a more minor role."

c. Private information drives shorting. This is important because, as pointed out in the paper,

"Ideally one would like to know if shorting indicators have explanatory power abstracting from public information (signaling the potential importance of market frictions), or if they are simply correlated with underlying movements in publicinformation flow."

And they find that private information seems to be more important.

d. The authors find that by following their strategy (that is when demand for shorts is high, sell), one would be presumed to beat the market on a

"net of shorting costs [basis], the investor still makes over 8% per year. Also, the Sharpe Ratio of the strategy is about 3 times that of the market and HML. Thus, indirect shorting costs (e.g., recall risk) and other indirect costs would have to be substantial to subsume this return."

Interesting to say the least!

Cite:

Cohen, Lauren H., Diether, Karl and Malloy, Christopher J., "Supply and Demand Shifts in the Shorting Market" (June 4, 2005). EFA 2005 Moscow Meetings Paper. http://ssrn.com/abstract=672381