Biased Shorts: Stock Market Implications of Short Sellers’ Disposition Effect

We investigate whether short sellers are subject to the disposition effect using a novel dataset that allows to identify the weekly closing of short positions. Consistent with the disposition effect, the closing of short sale positions is strongly related to a proxy of Shortsale Capital Gains Overhang (SCGO). Furthermore, while short sellers in general exhibit skill in closing their positions – i.e. closing is followed by positive stock returns – the closing explained by SCGO is followed by negative returns. This suggests that the trades are irrational and caused by the disposition effect. Next, we study the implications of short sellers’ disposition effect on stock prices. We provide evidence that SCGO is negatively related to future stock returns. This effect exists after controlling for the standard effect of capital gains overhang of other market participants. A trading strategy based on SCGO achieves yearly three-factor alphas of up to 26%. Overall, our results suggest that short sellers, instead of arbitraging away the mispricing caused by the disposition effect of the other market participants, add to this mispricing due to their own behavioral biases.