Short Selling and the Informational Efficiency of Prices

Abstract:     
We present direct empirical evidence that short sellers enhance the informational efficiency of prices. Using daily shorting flow data for a large panel of NYSE-listed stocks, we first show that greater shorting flow reduces deviations of transaction prices from a random walk. Second, at lower frequencies, we show that more shorting flow accelerates the incorporation of public information into prices. Third, greater shorting flow eliminates post-earnings announcement drift for negative earnings surprises. Fourth, we demonstrate that short sellers change their trading around large return events in a way that aids price discovery. These results are robust to various econometric methodologies and model specifications. Overall, our results highlight the important role that short sellers play in the price discovery process.

Keywords: Informational efficiency of prices, short selling, post-earnings announcement drift, arbitrage

JEL Classifications: G14

Working Paper Series