New Study Highlights Practice of Informed Trading Prior to Analyst Downgrades

Posted: June 5, 2008 at 1:00 am, Last Updated: November 30, -0001 at 12:00 am

By Jennifer Edgerly

A new study by Mason finance professors reveals that not only are there abnormally high levels of short selling of NASDAQ stocks prior to the public release of analyst downgrades, but evidence suggests that the short sellers are informed traders.

Short selling is the practice of selling securities the seller does not then own, in the hope of repurchasing them later at a lower price. This is done in an attempt to profit from an expected decline in price of a security, such as a stock or a bond, in contrast to the ordinary investment practice, where an investor “goes long” by purchasing a security in the hope the price will rise.

Mason professors Stephen Christophe, Michael Ferri and Jim Hsieh conducted the study, the first of its kind to consider the overall magnitude and significance of short selling in the days preceding analyst downgrades.

“Research focusing on the practice of short selling is growing, and we wanted to build on that literature by examining the pattern of short selling around the time of downgrade announcements by analysts,” says Christophe. “We found that the evidence appears to suggest that these short sellers are informed traders and are able to take advantage of information by trading shares before negative information is revealed to the public.”

Evidence in the study supports what researchers refer to as the “tipping hypothesis,” which states that informed trading arises because short sellers benefit from a tip they receive from insiders aware of a forthcoming downgrade announcement.

The fact that the evidence strongly supports the tipping hypothesis raises serious issues regarding whether some clients of certain brokerage firms benefit from material private information about upcoming downgrades. If this indeed is the case, both analysts and investors violate the principle that all market participants deserve fair and equitable treatment.

“Our findings imply that the activity alleged in the recent complaint by the Securities and Exchange Commission regarding tipping in the case of the brokerage subsidiary of UBS AG might have been quite common,” says Christophe. “Thus, our work calls into question the fairness of the special treatment accorded to certain prominent groups of equity market participants, and this special treatment could be construed as a violation of SEC Rule 10b-5.”

The study found that average daily short selling three days prior to the downgrade date is about four times higher than its normal level and is significantly related to the subsequent negative share price reaction to the downgrade. Evidence suggests that this relationship is especially pronounced for downgrades that prompt the most substantial price declines.

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