Days to Cover and Stock Returns
The short ratio - shares shorted to shares outstanding - is an oft-used measure of arbitrageurs’ opinion about a stock’s over-valuation. We show that days-to-cover (DTC), which divides a stock’s short ratio by its average daily share turnover, is a more theoretically well-motivated measure because trading costs vary across stocks. Since turnover falls with trading costs, DTC is approximately the marginal cost of the shorts. At the arbitrageurs’ optimum it equals the marginal benefit, which is their opinion about over-valuation. DTC is a better predictor of poor stock returns than short ratio. A long-short strategy using DTC generates a 1.2% monthly return.
We thank Jeremy Stein, Charles Lee and seminar participants at Hong Kong University of Science and Technology, Baruch College, and Princeton University for helpful comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.