Short selling, informational efficiency, and extreme stock price adjustment

Using Chinese equity data from April 2009 to August 2020, we contribute to the literature by exploring the impact of short selling on stock prices in three aspects. First, we find that as short sellers become more active, stock price adjustments accelerate, and prices respond more swiftly to public information. Second, we investigate the trading behavior of short sellers during periods of extreme stock price fluctuations and reversals. Our empirical findings suggest that short sellers behave like contrarian traders during these periods and consequently, short sales reduce the stock price crash risk. Last, we find that in emerging markets dominated by individual investors, sentiment seems a key factor for short sellers to moderate market crashes. When the market experiences unexpected sudden plunges, short sellers become support buyers and reverse the previously bullish investor-dominated market sentiment, thus correcting mispricing and mitigating irrationality.

Automated summary

This study examines the impact of short selling on stock prices using Chinese equity data from April 2009 to August 2020. The findings show that increased short selling activity leads to faster stock price adjustments and quicker responses to public information. Additionally, short sellers act as contrarian traders during periods of extreme stock price fluctuations, reducing the risk of stock price crashes. Moreover, in emerging markets dominated by individual investors, sentiment plays a crucial role in short sellers' ability to mitigate market crashes.