Banning Short Selling Could Have Disastrous Consequences For The Options Market

Discussion in 'Wall St. News' started by archon, Sep 19, 2008.

  1. archon


    Banning Short Selling Could Have Disastrous Consequences For The Options Market

    Posted on
    in Industry
    by Mark S. Longo

    The Law of Unintended Consequences
    Whenever the government enacts sweeping reform of the financial markets, it is a good bet that there are going to be unintended consequences. When those reforms are made in an atmosphere of complete and utter panic, there is an even better chance that those unintended consequences will be disastrous. Such is the case with the recent ban on short selling in financial stocks.

    On its surface, the intention of the ban is laudable. After all, regulators don't want the current crisis in financial stocks to spill over into other aspects of the market, thereby triggering a broad economic collapse. However, resorting to a complete and utter ban of a legitimate function of the capital markets is not the way to solve this problem. In fact, it's more akin to putting a band-aid on a gunshot wound.

    Lehman Brothers, Merrill Lynch and the other firms directly involved in this crisis all had problems that were unrelated to short selling. This is hardly breaking news. In fact, if you've been reading this site for some time, then you've seen repeated warnings that positions in the OTC credit market were spiraling out of control. Fed governors, regulators and analysts have all been warning that these positions were becoming increasingly untenable. The implosion of the mortgage market was merely the catalyst for a chain reaction that had been brewing for some time.

    Short Selling & The Options Market
    When the regulators witnessed the selloff migrating to other financial stocks, some of which had even reported positive earnings, they decided to ban short selling in all financial names. Apparently, the lessons of the 1997 Malaysian financial crisis have not been fully digested in Washington.

    That brings us back to the law of unintended consequences. Although the ban on short selling was designed to stem the hemorrhaging in the equity market, it could end up having a very chilling effect on the options market.

    The reasons for this chilling effect are obvious. After all, in the most basic terms, options are insurance for the financial market. Investors rely on options market makers to provide them with a safety valve for their portfolios. In times of crisis, demand for that insurance (primarily in the form of put options) skyrockets.

    Of course, market makers aren't magicians. If they are providing a risk outlet for investors, they have to find their own outlet for hedging that risk. Under normal circumstances, they would hedge the risk from short put options by selling stock. That's where the law of unintended consequences kicks in, and that's where the trouble begins.

    Impossible To Borrow
    As a result of this ban, market makers that are performing a completely legitimate and necessary function now have one hand tied behind their backs. By limiting their ability to hedge with short stock, the regulators have limited their ability to provide a crucial safety valve for the market during this crisis.

    If the regulators had taken the time to think through the law of unintended consequences, they might have made an exception for options market makers. That is the case in Britain, where options market makers are still allowed to perform their duties in spite of a similar ban on short selling in financial stocks.

    But in our rush to stem the bleeding in the broad market, we may have taken a step that is ultimately more damaging than the excessive volatility brought on by rampant short selling.

    The Worst Is Yet To Come
    Under normal circumstances, there would be other ways for market makers to spread off the risks associated with a ban on short selling. However, the effect of this ban is compounded by the extremely one-sided nature of the paper flow in many of these financial names.

    In the midst of any crisis, options market makers have to carry out a difficult balancing act. With customers lining up to buy puts and sell calls, the options (pun intended) for mitigating their own position risk are very limited. Being able to short stock against your option positions is a crucial part of that balancing act. Now that delicate balance has been destroyed. When you combine one-sided paper flow with a ludicrous ban on short selling, you have a recipe for disaster.

    We will begin to see the impact of this ban on Monday. If there is no market maker exception in place soon, then you can expect to see market makers slowly running out of ways to hedge their risk exposure. This will correspond with dramatic shifts in volatility skews and explosions in option premiums, particularly put options. After all, market makers cannot provide liquidity that they do not posses. Thanks to the law of unintended consequences, we may all be in for a bumpy ride in the days ahead.

    full article available here:
  2. Think about it.. IBKR is a big MM. Would their earnings get wiped by unhedged risk? or would volatility premiums make up for it, actually increasing their earnings? Or would likely decreased options volumes offset this gain or contribute to even worse performance?

    One thing is clear to me... The volume will likely move to CME futures options for at least indexes. There proper hedging can take place.

    Also.. Why won't DITM call shorts just work to replicate short stock? Any difference in margin req for MM in short DITM calls vs short outright?
  3. Take risk with the rest of us. Charge more. give the suckers a chance instead of a hedging banging a company with fake news articles, rumors, fake stock, and fake stock from a MM.

    I'd rather pay 2 bucks and have a chance, than one in a fixed game.

    Who ordained these guys so they could do business like bookies/?
  4. The author of this article obviuosly did not read the sec release on their ban. If you are a registered market maker you can still short the stocks.
  5. cvds16


    if you don't know what you are talking about please shut the fuck up, or better start making markets in options yourself. But I guess you are too stupid for that, ha !