| This paper considers the effect of private information on the returns to stocks with high levels of short interest. Using a structural trade model from the market microstructure literature, I model the impact of short selling constraints on the probability of information based trade (PIN). The model shows that PIN increases as the constraint on informed short selling is lowered. Empirically, I estimate PIN for a sample of high short interest stocks and form monthly portfolios based on PIN. After controlling for size, book-to-market, and momentum, I find that high PIN portfolios generally produce negative abnormal returns, while low PIN portfolios do not. Cross-sectional tests at the individual firm level confirm a significant negative relation between PIN and returns to high short interest stocks, suggesting superior explanatory power over the short interest ratio alone. The results support three main conclusions. First, some stocks with high levels of short interest do underperform. Second, the underperformance of high short interest stocks may be limited to stocks with high levels of informed trading. Finally, if PIN is a valid proxy for informed trading, then asymmetric information models offer new insights for the returns to high short interest stocks. |
