Short Interest, Bearish Option Trades, and Short-Sale Constraints

Abstract

Recent research has focused on the information content of short sales. In the plain vanilla capital asset pricing model, shorting a stock one thinks is priced too high is symmetrical with buying a stock one thinks is undervalued. However, there are several impediments to short selling in the real world that break the symmetry. A classic argument by Miller holds that when investors have heterogeneous beliefs about a stock but the market constrains short sales by the pessimists, the optimists will bid the price up too high and future returns will underperform. Because shorting is not actually prohibited, the question arises as to whether a stock with a relatively high level of short interest has a higher than average degree of latent pessimism (bad news for future returns) or, alternatively, is subject to no more negative beliefs than other stocks (no news) but has lower than average costs to short selling. Furthermore, the introduction of options trading creates alternative ways for investors with negative information to trade on their views by buying puts or writing calls. Du presents strong evidence supporting Miller’s argument and shows that high relative short interest is a signal of overpricing; high dispersion of opinion (as shown in earnings forecasts) and high short interest both are associated with overpricing and reinforce each other, and bearish option trades are a substitute for short sales.