Does the activity of short selling plays an important role in the financial markets?

Short sellers are widely regarded as being sophisticated investors, but their role is controversial. On one hand, given the nature of short selling - gaining profits from price decline, short sellers are often being blamed for causing or deteriorating market crashes. On the other hand, empirical evidence suggests that short selling helps identifying overpriced stocks through their advanced analytical skills and access to private information before public disclosures. 

I believe short selling plays a prominent role in facilitating price discovery, not only in regular market conditions but also during times of crisis. In one of my recent research projects, Short-Selling Activities in the Time of COVID-19 (2023, co-authored with Dr Ellie Luu and Dr Fangming Xu), we analysed daily short sale volumes in response to the initial global COVID-19 outbreak in early 2020. We report the intriguing result that, despite short sellers targeting COVID-sensitive firms, which may have exacerbated the stock price decline in these shares, the majority of short-selling activities remained concentrated in overpriced stocks in stock market. Hence even in a time of crisis, overall short-selling activity helped to improve the markets.

In addition to their role in identifying (and correcting) overpriced stocks, short selling also signals potential stock underpricing. Findings from my prior research project, Anticipating the value of share repurchase announcements: The role of short sellers (2021), demonstrate that short sellers are incentivized to identify underpriced stocks for the purpose of preventing potential losses. The implication is that short sellers are able to identify both underpriced and overpriced stocks, and hence stabilize market volatility. In sum, the existence of short selling activities can serve as another information channel to speed up the correction of mispricing.

Although short sellers are generally recognised as being sophisticated investors who can help improve and enhance stock market efficiency, it is important to acknowledge that short sellers can also propagate false information, either due to a lack of any information advantage or for the purpose of stock price manipulation. Empirical findings in my research project, Whose opinion matters when insiders disagree with short sellers? (2022, co-authored with Dr Shuo Wang), indicate that short selling signals are not always trustworthy as short sellers may experience a glass ceiling in accessing private information when compared with the trades of corporate insiders (executives working for companies who trade in their own company shares).

When making regulatory decisions, policymakers should carefully weigh the potential benefits and downsides of short selling. In light of the important and positive functions of short selling  - liquidity provision and price discovery - policymakers should exercise caution before implementing a temporary short selling ban in response to future stock market crises. A thoughtful and comprehensive approach to short selling regulations should be pursued, ensuring that they are equitable, effective, and efficient. 

*The views expressed herein are those of the author and do not necessarily reflect the position of the University of Bristol.