Short positions, size effect, and the liquidity hypothesis: implications for stock performance

Abstract

This study focuses on the relationship between short interest and subsequent stock returns. It also deals with the question of whether this relationship itself is attributable to firm size. In this context, this study investigates: (1) whether short sellers are correct in their predictions and whether these predictions can benefit other investors, (2) whether returns on short positions are related to firm size, and (3) whether the liquidity hypothesis or the differential information hypothesis can explain the relationship between firm size and short selling. The results support the notion that short sellers made correct predictions of price movements during the sampling period, 1986-1990. The results also show that following the monthly report of short interests, investors can still earn higher returns on shorted stocks, especially the small ones. Finally, the results maintain that short interest positions on less-liquid overpriced small stocks are more profitable than more-liquid overpriced large stocks, thus supporting the liquidity hypothesis. Overall these findings do not display seasonal differences, especially in January.