In a surprising discovery that challenges conventional market beliefs, researchers have found that informed short sellers do more than simply profit from anticipated stock declines, they actively supply liquidity in the market, especially on key news days.
This finding, from a new study by Assistant Professor Amar Soebhag and Associate Professor Esad Smajlbegovic of Erasmus School of Economics, together with co-authors Prof. Amit Goyal (University of Lausanne) and Prof. Adam V. Reed (Kenan-Flagler Business School), uses detailed transaction data from U.S. equity exchanges to explore how different types of short sales impact market dynamics.
Informed traders as liquidity providers
Traditionally, short sellers are seen as liquidity demanders, as they place trades to quickly leverage their informational edge, often widening the bid-ask spread and potentially reducing liquidity. However, the study reveals that the most informed short sellers actually tend to provide liquidity, often placing limit orders that help keep bid-ask spreads narrow, even as they profit from future price movements. This strategic liquidity supply from informed traders enhances price efficiency without the adverse effects typically associated with informed trading.
Liquidity provision on news days
Amar Soebhag and Esad Smajlbegovic, together with Amit Goyal and Adam V. Reed, found that liquidity-supplying short sales predict stock returns better than those that demand liquidity, with a notable increase in predictive power on news release days. This effect suggests that informed short sellers selectively act on long-term information, using liquidity-supplying trades to benefit from gradual price corrections rather than rapid, short-lived market shifts.
This study highlights a unique role for short sellers, indicating that they can both improve price efficiency and contribute to market stability by providing liquidity, a finding that could reshape how regulators and investors view short-selling activities during periods of market volatility.
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For more information, please contact Ronald de Groot, Media & Public Relations Officer at Erasmus School of Economics, rdegroot@ese.eur.nl, mobile: +31 6 53 641 846.
