Security price formation and informed trading with constrained short selling

  • Tyler R. Henry
Original Research


Short sale orders account for a substantial portion of trading volume in recent years. This paper develops a sequential trade model with constrained short selling to derive the effect on prices when the market maker can observe short selling in the order flow. The model predicts that market quotes will adjust differently to short sales and regular sales. Furthermore, the model shows that the probability of informed trading is impacted both by the level of short sale constraints and the intensity of actual short sale trades. Simulation evidence confirms that estimates of the probability of informed trade are improved when accounting for past short selling activity. The results demonstrate the information benefits of short selling transparency.


Short sale constraints Sequential trade model Informed trading 

JEL Classification

G12 G14 



I am grateful for financial support from the Frank H. Jellinek, Jr. Endowed Assistant Professor Chair in Finance.


  1. Akbas F, Boehmer E, Erturk B, Sorescu S (2017) Short interest, returns, and unfavorable information. Financ Manag 46:455–486CrossRefGoogle Scholar
  2. Anand A, Chakravarty S, Martell T (2005) Empirical evidence on the evolution of liquidity: choice of market versus limit orders by informed and uninformed traders. J Financ Mark 8:288–308CrossRefGoogle Scholar
  3. Angel J (1997) Short selling on the NYSE. Working Paper, Georgetown UniversityGoogle Scholar
  4. Asquith P, Pathak P, Ritter J (2005) Short interest, institutional ownership, and stock returns. J Financ Econ 78(243):276Google Scholar
  5. Bagehot W (1971) The only game in town. Financ Anal J 27:12–14CrossRefGoogle Scholar
  6. Boehmer E, Wu J (2013) Short selling and the price discovery process. Rev Financ Stud 26:287–322CrossRefGoogle Scholar
  7. Boehmer E, Jones C, Zhang X (2008) Which shorts are informed? J Finance 63:491–527CrossRefGoogle Scholar
  8. Brent A, Morse D, Stice E (1990) Short interest—explanations and tests. J Financ Quant Anal 25:273–289CrossRefGoogle Scholar
  9. Brockman P, Yan X (2009) Block ownership and firm-specific information. J Bank Financ 33:308–316CrossRefGoogle Scholar
  10. Burdett K, O’Hara M (1987) Building blocks: an introduction to block trading. J Bank Financ 11:193–212CrossRefGoogle Scholar
  11. Chen Q, Goldstein I, Jiang W (2007) Price informativeness and investment sensitivity to stock price. Rev Financ Stud 20:619–650CrossRefGoogle Scholar
  12. Choy S, Zhang H (2018) Public news announcements, short-sale restriction and informational efficiency. Rev Quant Finance Acc. Google Scholar
  13. Christophe S, Ferri M, Hsieh J (2010) Informed trading before analyst downgrades: evidence from short sellers. J Financ Econ 95:85–106CrossRefGoogle Scholar
  14. Collin-Dufresne P, Fos V (2015) Do prices reveal the presence of informed trading? J Finance 70:1555–1582CrossRefGoogle Scholar
  15. Copeland T, Galai D (1983) Information effects on the bid-ask spread. J Finance 38:1457–1469CrossRefGoogle Scholar
  16. Cremers M, Weinbaum D (2010) Deviations from put-call parity and stock return predictability. J Financ Quant Anal 45:335–367CrossRefGoogle Scholar
  17. D’Avolio G (2002) The market for borrowing stock. J Financ Econ 66:271–306CrossRefGoogle Scholar
  18. Desai H, Ramesh K, Thiagarajan S, Balachandran B (2002) An investigation of the informational role of short interest in the Nasdaq market. J Finance 57:2263–2287CrossRefGoogle Scholar
  19. Dey M (2001) Order time, multiple shocks, and short selling in security price adjustment. Working Paper, University of MassachusettsGoogle Scholar
  20. Dey M, Kazemi H (2008) Bid ask spread in a competitive market with institutions and order size. Rev Quant Finance Acc 30:433–453CrossRefGoogle Scholar
  21. Diamond D, Verrecchia R (1987) Constraints on short-selling and asset price adjustment to private information. J Financ Econ 18:277–311CrossRefGoogle Scholar
  22. Diether K, Lee K, Werner I (2009) Short-sale strategies and return predictability. Rev Financ Stud 22:575–607CrossRefGoogle Scholar
  23. Easley D, O’Hara M (1987) Price, trade size, and information in securities markets. J Financ Econ 19:69–90CrossRefGoogle Scholar
  24. Easley D, O’Hara M (1992) Time and the process of security price adjustment. J Finance 47:577–605CrossRefGoogle Scholar
  25. Easley D, Kiefer N, O’Hara M, Paperman J (1996) Liquidity, information, and infrequently traded stocks. J Finance 51:1405–1436CrossRefGoogle Scholar
  26. Easley D, Kiefer N, O’Hara M (1997) One day in the life of a very common stock. Rev Financ Stud 10:805–835CrossRefGoogle Scholar
  27. Easley D, Hvidkjaer S, O’Hara M (2002) Is information risk a determinant of asset returns? J Finance 57:2185–2221CrossRefGoogle Scholar
  28. Easley D, Engle R, O’Hara M, Wu L (2008) Time-varying arrival rates of informed and uninformed trades. J Financ Econom 6:171–207CrossRefGoogle Scholar
  29. Figlewski S, Webb G (1993) Options, short sales, and market completeness. J Finance 48:761–777CrossRefGoogle Scholar
  30. Gervais S (1995) Market microstructure with uncertain information precision: a new framework. Working Paper, University of PennsylvaniaGoogle Scholar
  31. Glosten L, Milgrom P (1985) Bid, ask and transaction prices in a specialist market with heterogeneously informed traders. J Financ Econ 14:71–100CrossRefGoogle Scholar
  32. Gu A, Yang C (2007) Short sales constraints and return volatility: evidence from the Chinese A and H share markets. Rev Pac Basin Financ Mark Policies 10:469–478CrossRefGoogle Scholar
  33. Hackney J, Henry T, Koski J (2018) Arbitrage vs. informed short selling: evidence from convertible bond issuers. Working Paper, University of South CarolinaGoogle Scholar
  34. Harris L (2003) Trading and exchanges. Oxford University Press, New YorkGoogle Scholar
  35. Hasbrouck J, Sofianos G, Sosebee D (1993) New York stock exchange systems and trading procedures. NYSE Working Paper #93-01Google Scholar
  36. Huang R, Stoll H (1996) Dealer versus auction markets: a paired comparison of execution costs on NASDAQ and the NYSE. J Financ Econ 41:313–357CrossRefGoogle Scholar
  37. Jain C, Jain P, McInish T (2012) Short selling: the impact of SEC Rule 201 of 2010. Financ Rev 47:37–64CrossRefGoogle Scholar
  38. Jarrow R (1980) Heterogeneous expectations, restrictions on short sales, and equilibrium asset prices. J Finance 35:1105–1113CrossRefGoogle Scholar
  39. Kaniel R, Liu H (2006) So what orders do informed traders use? J Bus 79:1867–1913CrossRefGoogle Scholar
  40. Karpoff J, Lou X (2010) Short sellers and financial misconduct. J Finance 65:1879–1913CrossRefGoogle Scholar
  41. Kolasinski A, Reed A, Thornock J (2013) Can short restrictions actually increase informed short selling? Financ Manag 42:155–181CrossRefGoogle Scholar
  42. Merton R (1987) A simple model of capital market equilibrium with incomplete information. J Financ 42:483–510CrossRefGoogle Scholar
  43. Miller E (1977) Risk, uncertainty, and divergence of opinion. J Finance 32:1151–1168CrossRefGoogle Scholar
  44. Senchack A, Starks L (1993) Short sale restrictions and market reaction to short-interest announcements. J Financ Quant Anal 28:177–194CrossRefGoogle Scholar
  45. Vega C (2006) Stock price reaction to public and private information. J Financ Econ 82:103–133CrossRefGoogle Scholar
  46. Wu C, Li Q, Wei K (1996) Incomplete-information capital market equilibrium with heterogeneous expectations and short sale restrictions. Rev Quant Financ Acc 7:119–136CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media, LLC, part of Springer Nature 2018

Authors and Affiliations

  1. 1.Frank H. Jellinek, Jr. Assistant Professor of Finance, Farmer School of BusinessMiami UniversityOxfordUSA

Personalised recommendations