Short sell studies gain international recognition

Faculty member Thomas Boulton

Beyond the world of finance, many may be unfamiliar with the trading practice of “short selling,” much less its sibling, “naked short selling.” But those who understand the financial strategies know that the practices drew heavy fire from the U.S. Securities and Exchange Commission (SEC) in the Fall of 2008.

Farmer School faculty member Thomas Boulton (finance) and colleague Marcus Braga-Alves of Marquette University decided to examine the recent SEC regulations that prevent investors from naked short selling of 19 financial stocks. In their paper, “The Skinny on the 2008 Naked Short Sale Restrictions,” the authors conclude that such short sale restrictions actually damage market quality, and can result in overpriced securities, higher trading costs, and lower trading volume.

“The worldwide financial crisis has placed short sellers, and especially naked short sellers, in the crosshairs of critics of the practice,” says Boulton, who explains these practices of making investments that profit from stock price declines.

“In a typical short sale transaction, an investor who believes that a stock is overpriced borrows the stock and sells it,” relates Boulton. “Short sellers profit if the price of the stock drops, which allows the short seller to repurchase the stock at the lower price to return it to the lender. The profit is the difference between the price at which the stock was sold and the price paid to buy it back, minus some commissions and expenses. Naked short sellers also profit from declining stock prices. However, unlike the short sale described above, the naked short seller does not borrow the shares before selling them.”

In a second paper, “Naked Short Selling and Market Returns,” Boulton and Braga-Alves examine the behavior of naked short sellers and the stock market reaction to information about their activities. Their results, reports Boulton, contradict the notion that naked short sellers are abusive, manipulative, and informed, and instead suggest that naked short sellers play a positive role in well-functioning markets by providing liquidity, bearing risk, and selling stocks they view as overpriced.

These two papers have received international attention from researchers, media outlets, bloggers, and policy makers. In addition to numerous citations in academic research, their papers have been referenced in Les Echos (France) and the Financial Times (Germany). Their study on the 2008 Emergency Order was profiled by The World Federation of Exchanges, a trade association of 51 publicly regulated stock, futures, and options exchanges, in their statement on short selling bans. Additionally, the two authors’ work was an integral part of FT Knowledge Management’s white paper, “Briefings on Market Practice: Short Selling.”

Boulton and Braga-Alves were invited to present their findings Oct. 9 at a conference, "Short Selling: Costs and Benefits," hosted by the Federal Reserve Bank of Atlanta. Boulton will speak on "Naked Short Selling and Market Returns."

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