Ban on Short Selling Could Have Negative Consequences for Options Market 12 comments
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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 (LEH), Merrill Lynch (MER) 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.
Disclosure: None
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 today. 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.
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This article has 12 comments:
which had risen to stupid prices as the herd rushed in to buy anything listed.
The spread between the bid and ask prices on the puts were so absurd that had I gone forward with the buys, I would have been in the hole for thousands of dollars immediately upon effecting the transactions.
Naturally, I took a pass on the puts. The 2 gaming stocks later sold off about 60% of their price rises, but still only reached the bid prices of earlier that day ! Insane !
Impossible to make any money being rational.
Another unintended consequence appears to be the rise in oil prices since the nationalization of our stock market, The price of oil has now gone back up where it should not be. Obviously, we all are going to pay dearly at the pump as well as increased taxes...Nice double-whammy !
Naturally, the "nationalization" has critics on all sides, especially the usual red-meat conservatives screaming socialism. We had to do something to effect a sea-change in the markets. As usual the comatose SEC, especially the astonishingly inept Cox, have now gotten around to noticing some "problems" systemic in the system. Just a tad late on the scene as usual.
Bottom line is; if you have the Washington cesspool of politicians and their masters, aka: lobbyists, directing our markets, that can't be good,
can it ? Duh !!
If I weigh the benefits and costs it is clearly preferable to force market makers to play by some sort of rules at least.
And if you are an investor, you usually need not hedge your position by buying puts: if you think the stock is worth holding at 50$/share, you will love to buy more at 30$ and you won't sell at $20, except if the business has deteriorated so much as that the stock is a sell. but then you sell it - you need not hedge it.
You want simple answers, simple tools and a simple market, something which has never existed and never will. All this kind of anti-intellectual thinking does is result in the election of simple minded presidents, 'nuff said.
The funniest comment here is "gamblers make it hard for investors"..lol. Good grief, what do you think the stock market is, anyway? A guaranteed ATM if you just buy a stock and hold on tight? From the day the very first ship left Holland, and stocks in the venture were sold on the first stock exchange, it has always been a 'gamble' to invest in a company. Daytraders, large investment banks and hedge funds trade and flip stocks every second of every day, creating liquidity and volume which creates the market. Shorting has existed for over 300 years, don't you think there might be a reason for that, besides another dark conspiracy to keep you down? Do I really have to explain this? Liquidity permits volume and correct pricing of assets. Buying low and selling high is the formula for profit, and without shorting, assets become overvalued, only creating a bigger decline down the road. The goal of the money game is profit, not sure what you're here for. Sounds like you're looking for boogeymen and a witch hunt.
The 'four legs good, two legs bad" black/white thinking on display on these boards lately is truly frightening. Make a note for yourselves to go back and re-read Jesse Livermore and the other basic lessons. That old "evil shorters ate my stocks" mentallity is one I'd expect to see on a penny stock message board, not in comments of a supposedly intelligent site like Seeking Alpha. Good luck storming the castle, boys.
naked shorting should be banned, but not regular shorting. Now, we, U.S. tax payers, bear all the problems caused by those private companies. I don't know why!!!!!