Short selling and options trading: A tale of two markets

• Published date: 01 June 2022
• Author: George D. Cashman,David M. Harrison,Hainan Sheng
• Date: 01 June 2022
• DOI: http://doi.org/10.1111/jfir.12276

Received: 10 October 2020

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Accepted: 5 April 2022

DOI: 10.1111/jfir.12276

ORIGINAL ARTICLE

Short selling and options trading: A tale

of two markets

George D. Cashman

1

|David M. Harrison

2

|Hainan Sheng

3

1

Department of Finance, College of Business

Administration, Marquette University,

Milwaukee, Wisconsin, USA

2

Department of Finance & Dr. P. Phillips

School of Real Estate, College of Business

Administration, University of Central Florida,

Orlando, Florida, USA

3

College of Business Administration,

University of Missouri–St. Louis, St. Louis,

Missouri, USA

Correspondence

David M. Harrison, Department of Finance &

Dr. P. Phillips School of Real Estate, College

of Business Administration, University of

Central Florida, Orlando, FL 32816, USA.

Email: david.harrison@ucf.edu

Abstract

Recent research documents both short selling and option

volume are predictive of future real estate investment trust

(REIT) returns, suggesting informed investors exploit their

informational advantage in both the traditional equity and

derivative security markets. However, little work has explicitly

examined the factors influencing which of these markets

informed investors choose to engage when transacting. We

address this gap in the literature and find clear evidence that

the risk associated with short selling is a significant driver of

this decision. Specifically, using a sample of 124 unique equity

REITS with both active short selling and option markets over

the past 10 years, we find that when short selling is riskier,

option volume is more predictive of future returns. These

results suggest that investors view options as an alternative to

shorting, and their decision to transact in the derivatives

market is materially influenced by short‐selling risk.

JEL CLASSIFICATION

G11, G12, G14, R30

1|INTRODUCTION

It has long been recognized that transactions costs and trading frictions often lead to pricing inefficiencies. For

example, Miller (1977) asserts that risky assets can easily become overvalued when short selling is costly and

investors have heterogeneous beliefs regarding valuations. Building on this logic, subsequent researchers argue that

the level of short selling should be related to a firm's subsequent returns. Supporting this contention, empirical

studies consistently find evidence that more heavily shorted firms do indeed exhibit lower subsequent returns,

J Financ Res. 2022;45:313–338. wileyonlinelibrary.com/journal/JFIR

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© 2022 The Southern Finance Association and the Southwestern Finance Association.

thereby suggesting short sellers (as a group) are able to identify overvalued firms. Furthering this paradigm, recent

studies recognize that informed investors are not limited to the equities market to exploit their information

advantage.

1

Rather, an investor who has identified an overvalued firm may choose to either short the firm's shares

in traditional equity markets or transact in the options market (e.g., selling a call or purchasing a put).

2

As such,

option market trading activity and patterns may well be value relevant. Consistent with this notion, recent

investigations into the price informativeness of options market activity across both general financial (e.g., Johnson &

So, 2012; Zhang, 2018) and real estate investment trust (REIT; e.g., Cashman et al., 2021) markets document that

firms with higher levels of option trading volume exhibit lower subsequent returns. Together, these studies suggest

informed traders are present in both the short‐sale market and the options market, as both have been documented

to exhibit predictive power with respect to subsequent returns.

Additionally, the literature presents compelling evidence of key operational linkages across these two markets.

Of note, Lamont and Thaler (2003) present evidence that investor purchases of put options are higher when the

cost of short selling is high. Similarly, Lin and Lu (2016) find evidence of a link between the costs of borrowing

shares for shorting and put option volume, and Chen et al. (2020) find that reductions in the frictions associated

with short selling (i.e., suspending the short‐sale price test) are associated with reductions in the volume of

corresponding put options. In sum, these studies suggest that as the costs of transacting in the short‐sale market

increase, informed traders move to the options market. However, these studies generally examine the predictive

power of short‐sale and options markets in isolation, whereas studies examining the linkages between these two

markets focus on the costs associated with short selling. These studies ignore how the predictive power of one

market is affected by innovations in the other.

To remedy this gap, we directly investigate the impact of the risks associated with short selling, as well as

explore the predictive power of each market simultaneously. In our article, short‐selling risk refers to one of the key

market frictions associated with short selling. Specifically, following D'Avolio (2002), we examine the impact that

the volatility in the fees associated with borrowing equity shares to be shorted exerts on subsequent REIT returns.

This is fundamentally different from an examination of the level of short selling, as instead of looking at the number

of investors who are willing and able to overcome the market friction associated with short selling, we examine the

impact of the friction itself on REIT market performance. Using this approach enables us to examine how this

friction in the equity marketplace influences the general relation between the equity market and the options

market, and more specifically, how the predictability of option volume is influenced by short‐selling frictions.

Throughout this investigation, we focus on the REIT market. REITs are uniquely suited for this investigation

because of their operational characteristics. They are characterized by high levels of option coverage, as noted by

Diavatopoulos et al. (2011), Borochin et al. (2017), and Cashman et al. (2021). Moreover, REITs are also

characterized by high levels of institutional ownership. More specifically, although Baghdadi et al. (2018) and

Ramalingegowda et al. (2021) find that 30%–40% of non‐REIT firm shares are owned by institutional investors, a

quick examination of 13‐F filing data for REITs suggests these numbers are approximately twice as high as their

non‐REIT counterparts, with a mean (median) of 76.0% (81.4%). This provides a ready supply of both lendable

shares and informed traders, thus satisfying a pair of necessary conditions for a deep short‐sale marketplace. In

addition to the presence of an active options and short‐sale market, the highly localized nature of the commercial

property market, where the cash‐flow potential of any individual property is highly dependent on the local

economy, suggests the potential for numerous participants with access to value‐relevant private information. This

observation flows directly from Coval and Moskowitz (1999,2001), who find that investment professionals are

better able to evaluate firms to which they are geographically closer.

3

The potential presence of such informed

actors is a necessary precondition for the persistence of return predictability along the dimensions we examine.

1

Kim and Young (1991) demonstrate that the introduction of options trading represents a feasibility‐expanding change for investors.

2

Eckardt and Bagamery (1983) describe how short selling and options trading can serve as alternative means of creating a short position.

3

Hau (2001) and Ivkovic and Weisbenner (2005) also present evidence that investors' holdings of local companies outperform.

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