Can Liquidity Events Explain the Low-Short-Interest Puzzle? Implications from the Options Market*

Abstract

This paper argues that liquidity events in short selling, such as short squeezes, margin calls, and stock specialness, may be an important part of short-selling constraints. We gauge the importance of liquidity events by utilizing a market-based measure, which is the cost of using options to limit the potential losses of short selling. Our approach circumvents the typical endogeneity problem in directly estimating the magnitude of short-sale constraints. We show that the costs of insurance against liquidity events exceed the abnormal profits of short positions. Our results therefore suggest that liquidity events can impose substantial costs on short sellers, and may thus explain the low-short-interest puzzle.

Keywords: Short-sale constraints, Liquidity, Limits to arbitrage, Asset-pricing anomalies

JEL Classification: G12, G14