Short Selling and Financial Markets

Summary

In financial markets, short selling refers to a trade that makes money if an asset falls in value. Most commonly, short selling involves borrowing a share of a stock in the securities lending market, selling it on the stock exchange, and then repurchasing it at a later date. While short selling is traditionally associated with speculating on a stock price decline, it can be used for many purposes, including long-short pair trading, hedging, and market making.

Academic research has consistently found that short sellers are more informed than buyers, on average. Stocks with high levels of short selling tend to fall in value, earning profits for short sellers, which suggests they are skilled at identifying stocks that are overvalued. Moreover, periods with high short selling in the stock market tend to forecast future market-level declines. Despite the often-publicized view that short sellers cause stock market crashes and increase volatility, academic research largely finds that short sellers are important contributors to market quality and that their presence helps prices incorporate negative information and improves liquidity. Consistent with this, regulatory bans on short selling in the United States and Europe have been associated with degradations in liquidity and price discovery.