Short Selling and Excess Return Correlation
29 Pages Posted: 30 Oct 2017 Last revised: 18 Dec 2017
Date Written: December 3, 2017
We show that the number of common short sellers shorting two stocks can predict their four-factor excess return correlation one month ahead, controlling for many pair characteristics, including similarities in size, book-to-market, and momentum. We verify that this result holds out-of-sample and show that it can be used to establish a trading strategy that yields positive cumulative returns over 12 months. We explore the possible mechanisms that could give rise to this relationship. We find that neither the price-impact mechanism nor the liquidity-provision mechanism can explain the uncovered relationship. Rather, it seems that the relationship is due to informed short selling, which we identify using several indicators of value obtained from financial statement analyses.
Keywords: short selling, correlation, informed trading
JEL Classification: G14
Suggested Citation: Suggested Citation