The causal impact of short‐sale constraints on the idiosyncratic volatility puzzle

Abstract We investigate the causal impact of short‐sale constraints on the idiosyncratic volatility (IVOL) puzzle, where high‐IVOL stocks yield lower future returns. We leverage two opposing exogenous shocks to short‐sale constraints: (1) 2005 Regulation SHO, which relaxes constraints for pilot stocks, and (2) 2003 Jobs and Growth Tax Relief Reconciliation Act (JGTRRA), which tightens constraints during dividend record months. We find that short‐sale constraints significantly affect IVOL pricing: Regulation SHO weakens the IVOL effect for pilot stocks, whereas JGTRRA strengthens it after dividend record months. These findings underscore the importance of short‐sale constraints in understanding the IVOL puzzle.