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Comparing the information in short sales and put options

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Abstract

Prior work shows that both short sales and put options contain information about future stock prices. In this study, we compare the return predictability in short sales to the return predictability in put options. The motivation for this comparison is based on the theoretical argument that informed traders can choose between short sales and put options when establishing short positions in a particular stocks. Results in this paper suggest that the underperformance of stocks with high short-selling activity is approximately four times larger than the underperformance of stocks with high put-option activity. While stocks that are most likely to face binding short-sale constraints drive the underperformance caused by put-option activity, we still find that short sales are generally more informative about future prices.

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Notes

  1. Other studies (Senchack and Starks 1993; Aitken et al. 1998; Christophe et al. 2004; Boehmer et al. 2008; Dechow et al. 2001; Desai et al. 2002; Engelberg et al. 2010; Wu et al. 1996) also document that short sales contain information about future price movements. While studies show that short sales generally contain information, results regarding the informativeness of options is less conclusive. While some studies report empirical evidence that support the theory that informed trading varies between the options and stock markets (Anthony 1988; Cao et al. 2005; Easley et al. 1998; Mayhew and Stivers 2003; Pan and Poteshman 2006; Back 1993; Chan et al. 2002; Figlewski and Webb 1993; Gu and Yang 2007) Other papers question the level of informativeness in options trading (Wei et al. 2010; Stephan and Whaley 1990; Chan et al. 1993; Finucane 1999; Bhattacharya 1987; Kluger and Wyatt 1995).

  2. Qualitatively similar results are shown in Pan and Poteshman (2006).

  3. We also require stocks in our sample to have a CRSP share code of 10 or 11 thus eliminating securities that are not ordinary common stocks such as REITs, ETFs, Closed-End Funds, etc.

  4. In unreported tests, we rerun our entire analysis with partitioning the short-sale data into exempt and non-exempt short sales. The conclusions we draw are similar those reported in this paper that suggest that short sales (in general) contain more information about future returns that put-call ratios.

  5. We use three-factor risk-adjusted returns and raw returns throughout the analysis for robustness and find qualitatively similar results.

  6. Boehmer et al. (2008) also show that the return predictability of the short ratio remains for at least 20 days.

  7. We recognize that the scale of the short ratio and the put-call ratio differs. Therefore, we standardize both ratios similar to Lakonishok and Vermaelen (1986) and Koski and Scruggs (1998). In particular, we subtract the mean ratio for each stock (across the sample time period) from the ratio for each stock on day t. We then divide this difference by the standard deviation of each stock (across the sample time period). This standardization procedure allows each stock to have standardized ratio with a zero mean and a unit variance. With each stock having a similarly distributed standardized short ratio and standardize put-call ratio, we are able to compare the estimates for β 3 and β 4 .

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Authors and Affiliations

  1. Department of Economics and Finance, Utah State University, 3565 Old Main Hill, Logan, UT, 84322, USA

    Benjamin M. Blau

  2. Department of Finance and Economics, Mississippi State University, 312 M McCool Hall, Starkville, MS, 39762, USA

    Chip Wade

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  1. Benjamin M. Blau
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Correspondence to Chip Wade.

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Blau, B.M., Wade, C. Comparing the information in short sales and put options. Rev Quant Finan Acc 41, 567–583 (2013). https://doi.org/10.1007/s11156-013-0377-5

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