Short selling by individual investors: Destabilizing or price discovering?

This paper examines how individual investors' participation in short sale affects the efficiency of stock pricing using a unique regulatory change in Korea. The change enables individual investors to sell short some – but not all – domestic stocks, without affecting the short-selling ability of institutions. We find no evidence that individuals' participation in short sale destabilizes stock market. Specifically, our difference-in-difference estimates indicate that stocks show little change in their return volatility or skewness after they become shortable by individuals. Moreover, we find that stocks are traded within a narrower bid–ask spread and deviate less from the random-walk process after becoming shortable by individuals. Overall, our results suggest that at least some individual investors are privy to private information and they contribute to more efficient pricing via their short sales.

► We study a regulatory change that allows individual investors to short-sell stocks.
► The regulation has no effect on the short-selling ability of institutions.
► Stocks experience no increase in volatility or skewness after the regulatory change.
► Rather, those stocks experience a reduction in the bid–ask spread.
► Those stocks also show a smaller deviation from random walks.