Short sellers benefit when stock prices fall. In early 2021, large traders had substantial short positions in a company called Gamestop, an American video game retailer. Retail investors, who disliked these short sellers, coordinated through an internet forum to drive up the price of Gamestop. This stock price surge led to large losses for short sellers, with several of them being forced out of their positions. In recent research, I examine with Antonio Gargano and Juan Potes-Saladino whether losses to short sellers are common, and study more generally how these losses affect the efficiency of stock markets.
A short position in a stock leads to a profit when the stock price falls and results in a loss when the stock price increases. The practice of short selling has been compared to buying fire insurance on your neighbours’ house, because short sellers appear to benefit from other people’s misery. However, short sellers can also play a crucial role in financial markets by incorporating negative information into asset prices. When traders are not allowed to short sell, negative information might be underrepresented in stock prices and stock price bubbles may appear (in other words, prices might then be “wrong” and new investors would pay too high a price for the stock).
‘The practice of short selling has been compared to buying fire insurance on your neighbours’ house, because short sellers appear to benefit from other people’s misery’
Short sellers are typically sophisticated hedge funds. However, despite their sophistication, reports about short sellers’ losses have appeared in the financial press, also before the Gamestop example. In our paper, we use a novel dataset to examine the U.S. stock-level and aggregate running performance of short sellers, and we test how this performance feeds back into their future activity. As most companies’ stock prices increase in a typical year, random short selling is likely to lead to a loss for short sellers. Indeed, we find that a short seller in a typical stock makes a loss, but we also find that many short sellers are good at selecting the companies they take positions in. Short sellers, for example, make sizable profits on the most heavily shorted stocks. Many of them thus seem capable of predicting future stock prices, whereas other short sellers are confronted by losses.
Restrictions caused by losses
Do the (sometimes temporary) losses of some short sellers restrict them in their trading? We find that they do. We find that many loss-making positions are closed, especially when losses exceed 15%. This is in line with, for example, margin account regulations that require short sellers to deploy additional capital to maintain loss-making positions. The tendency to reduce short positions increases monotonically with the size of the losses. Short-selling constraints thus seem important in the U.S. stock market.
‘Short sellers who have experienced gains are also the ones that are skilled in predicting future stock price movements’
The final question we attempt to answer is whether the limits to short sellers hurt stock market efficiency. When loss-making short sellers are pushed out of the market, does this lead to prices being more “wrong”? We conclude that prices remain accurate. It turns out that the short sellers who have experienced gains are also the ones that are skilled in predicting future stock price movements, indicating their sophisticated trading ability. The short sellers that experience losses are overall substantially less informed about future returns. Hence, even though financial frictions can be pervasive, the short sellers they limit are the relatively uninformed investors, and we find that markets generally remain efficient when these short sellers are forced out of their positions.
Bio: Patrick Verwijmeren is Professor of Corporate Finance at Erasmus School of Economics. His research interests include capital raising, mergers and acquisitions, and investing in art.