Two Essays on Short Selling

Abstract

This thesis investigates the short selling activities of domestic individual investors and foreign investors in the Korean stock market. I examine the short selling of domestic individual investors at the transaction level and the short selling of foreign investors at the daily level. In the first part of this paper, I use an account level dataset of individual short sales to investigate individual investors short selling profitability in the Korean stock market from August 1, 2007, to May 31, 2010. Individual short sellers made an average profit of 12,660 Korean won (roughly USD 11.5) per trade per day. Moreover, about 31% of shorted trades were covered within a day (i.e., shorting and covering on the same day) and about 21% were covered the following day. Short selling profitability decreased as the number of days to cover increased, which suggests that mispricing was corrected very quickly, in less than two weeks, on average. I also find that profitable short sale trades are associated with high volatility, a narrow spread, high trading turnover, small firms, and firms with a low book to market, the most strongly associated characteristic being volatility. In account-level analysis, short sellers who trade more firms make higher profits than those who trade fewer firms. Finally, short sellers earn persistent positive abnormal returns. These results suggest that individual short sellers have superior information and employ short-term trading strategies. The second part of this paper investigates the daily short selling of foreign investors and their impact on stock prices, liquidity, and volatility in the Korean stock market from January 1, 2006, to May 31, 2010. I find that the majority of short sales were conducted by foreign rather than domestic investors and that foreign short sellers are contrarian investors, whose large numbers of short sales predict future short-run returns. I also find that foreign investors sell short when buying pressure is high but this does not improve stock liquidity. Furthermore, I find that foreign investors short selling does not increase volatility, providing evidence against the destabilizing role of foreign investors in emerging markets.