Substitution between Short Selling and Options Trading in Predicting Aggregate Stock Returns
50 Pages Posted: 31 May 2019
Date Written: March 2019
Splitting stocks into groups with and without options trading, we find that only the aggregate short interest index constructed by the stocks without options trading predicts market returns in both in-sample and out-of-sample tests. The return predictability is up to six months and does not revert. Similarly, when splitting stocks into groups based on short selling risks, we find only the aggregate option implied volatility spread constructed by the stocks with higher short selling risks predicts market returns. Overall, our results show that there exists a substitution effect between short selling and options trading in predicting aggregate stock returns. This substitution effect could explain the phenomena that aggregate short interest does not predict market returns in recent years, given the rapid development of the options market.
Keywords: Aggregate Short Interest; Options Trading; Market Return; Out-of-Sample Tests; Informed Traders
JEL Classification: C58, G12, G14, G17
Suggested Citation: Suggested Citation