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Mystery and speculation shrouds short sellers, also known as the “smart money.” Who are they? Where do they trade and why? In new research, Finance Professor Mehrdad Samadi of 51���� Cox and co-authors provide the first evidence of short sellers, or informed traders, trading venue of choice. Understanding traders’ strategies, price formation, liquidity and competition among trading venues is of high interest to stakeholders such as regulators, academics, and practitioners. Short seller’s choice of trading venue has implications for market design, says Samadi.

In the forthcoming paper “Shorting in Broad Daylight: Short Sales and Venue Choice,” Samadi and his co-authors find that a greater proportion of short sellers trade on public stock exchanges like the NYSE and NASDAQ versus dark pools. Dark pools are off-exchange platforms where orders are not publicly observable to other market participants and where orders are required to be matched within a consolidated bid-ask spread. Orders that match save on bid-ask spread costs and potentially have a smaller price impact. However, if no match exists within the bid-ask spread at the dark pool, a trade won’t take place.

Since informed traders are typically trading in the same direction, notes Samadi, they are either buying or selling. Thus, it’s harder to find counterparty to trade with unless the other party like a mutual fund is selling for other reasons, such as a hedge or to rebalance a portfolio. “Because of the risk of non-execution, [short sellers] choose exchanges because they want to get the trade done. If they can’t get trade done, they can’t profit off of their information,” says Samadi. Short selling, predominantly by hedge funds, is pretty opaque and secretive, he notes. “Reasons [of short selling] an overvalued stock include poor fundamentals and anticipation of major corporate events.”

Why does a greater proportion of short selling happen on exchanges versus dark pools? It’s due to an important difference in how these two types of trading venues are designed. The economics of it boils down to a tradeoff between transactions costs and the probability of being able to trade, according to Samadi. The probability of finding someone to trade with on dark pools is lower than on exchanges.

Research specifics

Leveraging the academic literature, the authors establish that short sellers are well-informed investors whose transactions tend to out-perform the market. They then examine venue choice of short sellers using data from individual stock exchanges and from FINRA (Financial Industry Regulatory Authority) which includes dark pool trades. They found that exchange short sales represent 45.7% of a stock’s exchange trading volume on average. Short sales executed in dark pools represent just 37.0% of a stock’s dark pool trading volume.

The results show that shorting on both exchanges and dark pools is associated with informed trading, producing positive returns. However, exchange short sales are significantly more informative than dark pool short sales. Heavily-shorted stocks in dark pools underperform corresponding lightly-shorted stocks by 0.53% on a risk-adjusted basis over the subsequent 20 trading days, or 6.41% annualized. The difference is more pronounced on exchanges: heavily-shorted stocks underperform lightly-shorted stocks by 0.89%, or 10.70% annualized.

The authors also find that the difference in return predictability is even larger on corporate news release days when short sellers are likely to have a larger information advantage. Thus, the timeliness of information and the ability to trade are important motivations for trading venue choice. Interestingly, on news release days, short selling on exchanges is 4.39 times more informative about future prices than on dark pools. Samadi notes that the literature shows that, “short sellers anticipate big corporate news events and use public information.”

The research highlights the impact of market design—that market design affects the trading strategies of traders. This has implications for how fast and how well prices are formed in financial markets. The findings are also relevant for liquidity in financial markets and how easy it is to trade, which importantly, impacts the many market participants.

The paper “Shorting in Broad Daylight: Short Sales and Venue Choice” by Mehrdad Samadi of 51����’s Cox School of Business, Adam Reed of UNC Kenan-Flagler Business School and Jonathan Sokobin of FINRA is forthcoming in Journal of Financial and Quantitative Analysis.

Written by Jennifer Warren.