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SSRN-id2019361[1]

SSRN-id2019361[1]

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Published by panazelia

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Categories:Types, Business/Law
Published by: panazelia on Apr 24, 2012
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04/24/2012

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Electronic copy available at: http://ssrn.com/abstract=2019361
 
Short SqueezeWei XuHSBC School of BusinessPeking UniversityandBaixiao LiuKrannert School of ManagementPurdue University
The potential for, and actual occurrence of, short squeezes are taken as a fact of life byprofessional investor but receive little attention from the academic community. In this study, wedocument systematic evidence of short squeezes in individual stocks and investigate thedeterminants of short squeezes. By examining stock returns following events of large one-dayprice increases, we report that an average short squeeze has a 3.25% impact on stock price andthis effect lasts for a day and half. Further, we find that the impact of short squeezes issignificantly correlated with event-day stock returns, short interest, institutional holdings, event-day market returns and event-day industry returns. We also find that the impact of short interest,institutional holdings, event-day market returns and event-day industry returns on short squeezesis more significant after the SEC’s adoption of Regulation SHO in 2005. In the aggregate, thisevidence suggests that the capital constraints of short sellers and the short sale constraints of individual stocks are key determinants of short squeezes.
March 2012
 
Electronic copy available at: http://ssrn.com/abstract=2019361
1
Short Squeeze1. Introduction
 According to the SEC:
“The term ‘short squeeze’ refers to the pressure on short sellers to cover their positions as aresult of sharp price increases or difficulty in borrowing the security the sellers short. The rushby short sellers to cover produces additional upward pressure on the price of the stock, whichthen can cause an even greater squeeze.”
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Short squeezes are taken as a fact of life by portfolio managers and other marketprofessionals. They are commonly cited in the news media as the reason for certain sharp priceincreases. Searching under the key word “short squeeze” over the period of January 1995through December 2009 on
Factiva
yields over 25,000 hits; assets mentioned in these articles asexhibiting short squeezes range from individual stocks to commodities to foreign currencies andeven to the equity market as a whole. Traders have gone so far as to develop a trading signalcalled “cushion theory” based on the potential occurrence of short squeezes. Cushion theorypredicts that the price of a stock rises with the level of short interest in that stock, especially if the short interest rises above twice its daily trading volume.
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Certain hedge funds andinstitutional investors have designed trading strategies to take advantage of the cushion theory.
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See the SEC website: http://www.sec.gov/spotlight/keyregshoissues.htm.
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Cushion Theory implies that a stock's price must rise if many investors are taking short positions in it becausethose positions must be covered by purchases of the stock. Technical analysts consider it particularly bullish if theshort positions in a stock are twice as high as the number of shares traded daily. This is because price rises forceshort sellers to cover their positions, making the stock rise even more. -
 Barron’s Dictionary of Finance and  Investment Terms, 7th edition,
2006.
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Merrill Lynch is reportedly developing such strategy. See “Short-Sellers May Lift Small Stocks --- Two StrategistsBet Practice Will Create a Floor or Allow Shares to Rise Even Higher” April 5
th
, 2004 WSJ.
 
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However, to the extent that academics have studied short interest, contrary to the cushiontheory, these studies report a robust negative relationship between short interest and short-termfuture returns (see for example, Figlewski and Webb (1993), Senchack and Starks (1993),Asquith and Meulbroek (1995), Dechow et al. (2001), and Desai, Ramesh, Thiagarajan, andBalachandran (2002)). These studies have not explicitly sought to explain whether shortsqueezes occur. Indeed, our search of academic literature uncovered no studies that empiricallyidentify the frequency and magnitude of short squeezes.
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The prevalence of short squeezesreferenced in the popular media and the absence of systematic evidence of short squeezes inacademic studies give rise to the question of whether short squeezes are the Sasquatches of financial markets – phenomena that are much discussed but never seen.In this paper we attempt to systematically document evidence of short squeezes in individualequities. In a sample of 26,343 events where liquid stocks experience a one-day return of 15%or more
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, we find that, after adjusting for risk, the next day prices experience an average reversalof -0.30% Moreover, the absolute value of the next day price reversal increases with the level of short interest and the magnitude of the prior day price jump (i.e. the event-day return);specifically, when both short interest and event-day return are in the highest decile, stocksexperience the largest price reversal of -3.25%. In contrast, for stocks with low short interest,prices increase, on average, by a small but insignificant amount on the day following the price
4
 
D’Avolio (2002) studies a different kind of short squeeze where the borrowed stocks by short sellers are calledback by their original owner.
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Illiquid stocks are actually more likely to be bound by the two necessary constraints. Moreover, in the unreportedresults, we find the effect of squeeze to be stronger for illiquid stocks. However, these stocks also have wide bid-ask spreads, which muddle the effect of short squeezes. For this reason, we choose to focus on liquid stocks to have aclear measure of the squeeze impact.
 

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