Days to Cover and Stock Returns∗

A crowded trade problem emerges when speculators’ positions are large relative to the liquidity of the asset, thereby making exit difficult. We study this problem, which has been a point of concern in the Dodd Frank Financial Reforms regarding systemic risk, through the lens of short-selling. We show in a simple model that days to cover (DTC), the ratio of short interest to trading volume, measures the costliness of exiting crowded trades. We find that arbitrageurs are worried about the crowding problem as short-sellers avoid illiquid stocks and require a significant premium to enter into such positions. A strategy shorting high DTC stocks and buying low DTC stocks generates a 1.2% monthly return. We show that there is a comparably large days-to-cover effect on the long positions of levered hedge funds. ∗We thank Jeremy Stein, Charles Lee and seminar participants at European Finance Association, Seoul National University, Hong Kong University of Science and Technology, Baruch College, and Princeton University for helpful comments. †Princeton University and NBER. ‡Hong Kong University of Science and Technology. §Hong Kong University of Science and Technology. ¶Columbia University, Princeton University, and NBER. ‖Goldman Sachs.