Short Selling In OTC Stocks: Information Or Manipulation?

Archana Jain

Rochester Institute of Technology

Chinmay Jain

University of Ontario Institute of Technology

May 5, 2016


We examine short selling activity in OTC stocks using short selling volume and short interest data for a period from 2009 to 2016. We find that on average short volume constitutes 48% of daily trading volume in OTC stocks. Similar to exchange traded stocks, a portfolio with short position in stocks with high short selling volume and long position in stocks with low short selling volume has significant positive returns. Surprisingly, this positive return reverses over a period of next 1-month, indicating manipulative short selling. OTC stocks have higher short selling after a period of positive returns and on days of positive returns. Unlike exchange-traded stocks, short interest does not have predictive power for future returns. Short interest increases when the return over the past 15 days is positive, but it is lower for stocks with positive return over the last 1 year.

Short Selling In OTC Stocks: Information Or Manipulation? – Introduction

Several studies have examined the asset pricing dynamics in the over-the-counter (OTC) market. OTC markets are far less liquid, disclose less information, and have lower institutional ownership compared to listed stocks (Ang, Shtauber, Tetlock (2013)). Based on their study, Ang, Shtauber, and Tetlock (2013) provide evidence that OTC stocks have higher short sale constraints and higher dispersion of opinion, making them overpriced and resulting in negative returns, on average. Eraker and Ready (2015) document that OTC stocks are generally small companies that have a high probability of failure and a small probability of success. The stocks in their sample have large negative average returns. This naturally makes OTC stocks an ideal target for short sellers as they profit from a fall in stock prices and with the failure of a company their profits would be much more pronounced. Eraker and Ready (2015) suggest that the low average return of OTC stocks reflects investors’ preferences for positively skewed stocks.

Engelberg, Reed, and Ringgenberg (2013) find that a substantial portion of short sellers’ trading advantage comes from their ability to analyze public information. OTC markets are less transparent and it makes it harder for short sellers to trade based on their ability to process public information. If short sellers trade in OTC markets, they may do so based on their private information or they may also manipulate stock prices in downward direction to make profits as these markets are less regulated. Ang, Shtauber, and Tetlock (2013) studies short selling in OTC stocks for a sample of 50 stocks and they find that Fidelity allows retail investors to short sell only 1 of those stocks (and only 8 out of 50 similarly sized listed-stocks). They also look at the short interest data for those 50 stocks and based on a smaller float as a % of shares outstanding, conclude that investors have difficulty in short selling OTC stocks. They fail to look at the actual short selling volume data and thus, they do not provide a complete picture of short selling in OTC markets. We aim to study short selling on a larger scale and to find the extent of short selling in OTC stocks and its impact on the performance of OTC stocks. When we study the short selling volume data for OTC stocks published by Financial Industry Regulatory Authority (FINRA), we find that on average, short selling constitutes 48% of the trading volume. This makes intuitive sense as the OTC markets should be more attractive to short sellers as they are less transparent, less liquid, and are not as regulated as exchange traded stocks. An average negative return in OTC markets also makes an attractive playground to short sellers. Thus, acquiring information about this stocks can result in potentially higher returns for traders. Also, as these markets are less regulated, it makes it easier for short sellers to manipulate stock prices in the downward direction. For example, ISM International (trading on the pink sheets) became a victim of short selling in 2012 and as a result contacted regarding the possibility of creating a documentary to expose what short sellers were doing. Within 1 day, 73% of ISML was shorted for no clear reason. Market Makers short against the orders that come in and then place a bid price much lower than current levels like predators. “I spend a great deal of the day explaining to my shareholders that we are being attacked. I have complained to the appropriate authorities, but no one seems to care,” says Mario Quenneville, CEO of ISM International.

Another stream of research focuses on the relationship of short selling activity with returns based on superior information of short sellers. These studies find that stocks that are shorted heavily underperform stocks that are shorted lightly (Boehmer, Jones, and Zhang, 2008) and short sellers are correctly able to predict stocks that will have future abnormal negative returns (Diether, Lee, and Werner, 2009). Some studies also find that aggressive short selling can amplify the magnitude of price declines (Shkilko, Van Ness, and Van Ness, 2013). All of these studies have examined stocks that are traded on exchanges, are liquid and have more transparent financial disclosures. We are interested in analyzing OTC stocks, which have different characteristics. These stocks are far less liquid and disclose less financial information to the public compared to the exchange-traded stocks. To the best of our knowledge, no study highlights the impact of short selling on the OTC stocks.

OTC stocks

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