Security price formation and informed trading with constrained short selling
Short sale orders account for a substantial portion of trading volume in recent years. This paper develops a sequential trade model with constrained short selling to derive the effect on prices when the market maker can observe short selling in the order flow. The model predicts that market quotes will adjust differently to short sales and regular sales. Furthermore, the model shows that the probability of informed trading is impacted both by the level of short sale constraints and the intensity of actual short sale trades. Simulation evidence confirms that estimates of the probability of informed trade are improved when accounting for past short selling activity. The results demonstrate the information benefits of short selling transparency.
KeywordsShort sale constraints Sequential trade model Informed trading
JEL ClassificationG12 G14
I am grateful for financial support from the Frank H. Jellinek, Jr. Endowed Assistant Professor Chair in Finance.
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