To Short or Not to Short

Abstract

In asset pricing literature, short-sellers are considered as informed traders as their trading behavior often signals adverse news about firm fundamentals (Akbas, 2016). In a frictionless stock market with no binding constraints on short-selling, informed short sellers freely trade based on their information. In most cases, institutional investors take the lead role in this activity and trade based on current conditional expectations of the firm’s value. It is obvious that in this process the better-informed investors gain while other retail investors lose money. Regulators across the world deal with this issue differently. While in Europe, hedge funds need to report their short positions to regulators (public) if it crosses 0.2% (0.5%) post-2012, in the US, the daily aggregate short positions of exchanges are maintained by Financial Industry Regulatory Authority (FINRA).1 Whether such regulatory mechanisms are enough or not is a debatable topic. However, it clearly shows that shorting is somehow under the regulatory rudder, especially after the global financial crisis. There are enough anecdotal pieces of evidence suggesting that institutional investors are better informed about the investment potential of a stock compared to their retail counterparts (Cai et al., 2010; Yan & Zhang, 2009). Still, recent events show no assurance that such superior information always transforms into economic benefit. One prominent example is the recent surge in the price of GameStop, a US-based video games store operator. This stock experiences a skyrocketed spike in price in the last week of January 2021 that leads to a huge economic loss of certain multi-billionaire hedge funds (short-sellers) and unexpected profit to few amateur retail investors. Astonishingly, it reveals the mighty influence of social media in generating abnormal valuation where fundamental analysis loses its logical significance.