Short sales constraints and momentum in stock returns

We show that stock characteristics identified by b14D'Avolio (2002) provide a reliable index of the mostly unobservable short sales constraints. Specifically, we find that this index is positively related to the level of short interest and to short selling costs implied by the disparity in prices in the options and stock markets, and is negatively related to future returns. Using this index, we show that the magnitude of momentum returns for the period 1984 to 2001 is positively related to short sales constraints, and loser stocks rather than winner stocks drive this result. We conclude that short sales constraints are important in preventing arbitrage of momentum in stock returns.