Short Covering

Abstract

We construct novel measures of net and gross short covering to examine when short sellers exit positions. We find that idiosyncratic limits to arbitrage, such as adverse stock price movements, volatility, and equity lending fees, are associated with significantly higher position closures. In contrast, we find little evidence that aggregate limits to arbitrage, including VIX, funding liquidity, and market liquidity, affect short covering. Short covering predicts future returns in the wrong direction, but only if it is induced by limits to arbitrage, consistent with the hypothesis that short sellers are forced to exit too early. It is also associated with lower price efficiency, higher future anomaly returns, and better performance of other informed traders. These results show that firm-level limits to arbitrage are important determinants of trading behavior and future returns.

Keywords: limits to arbitrage, market efficiency, short sales, short covering

JEL Classification: G12, G14