Inefficient Markets: Shorting, the VIX, and Unintended Consequences

I occasionally trade LEAPS and straddles. A couple weeks ago (Sep 22) I attempted to close out my last short position (a bear price spread on Goldman Sachs (GS)) after having a very heavy short bias in my option portfolio the past couple years. That is unfortunate because last week would have been a great time to have short positions. I’m still roughly 50% cash so I’m not broadly optimistic at the moment. However, there are some individual stocks trading at great valuations that I haven’t been able to ignore, even if I started cherry picking them a little early.

A somewhat frustrating result of the no short rule is the unusually high bid/ask spread in the option market. I called my broker and asked why he wasn’t jumping between the bid/ask spread to fill my option order. Granted I could have done this manually by splitting my trade, but with the excessive volatility recently I preferred avoiding this. My broker said that due to the no shorting rule the market maker was not jumping between the spread to fill orders, but was instead just letting clients name the spreads. I said that explains why there appears to be no market maker, because basically there wasn’t one.

I’m sure governments around the world didn’t care about option bid/ask spreads when outlawing shorting, but it has an impact on the efficiency of markets. The no shorting rule will probably keep the VIX elevated for some time. The past month has seen the VIX spike straight up. One consequence of this is that this has been and will continue to be a great time to trade options.

I typically avoid writing about option strategies as there are many that know far more than me. However, I’ve been surprised that no one (that I’ve heard) seems to have connected the suspension in shorting hundreds of companies with the spike in the VIX. I could elaborate on how government interventions to increase market efficiency will have many unintended consequences that could actually increase volatility, but I’ll leave that to “the experts”. Alas testing is something that exists only in traditional engineering; not financial engineering…

Disclosure: No position in any stock mentioned.

Comments

[Andy Abraham:]

With the VIX the highest on record... many of the members of Myinvestorsplace.com think we might be bottoming...what do you think??

2008 Oct 06 01:47 PM

[whidbey:]

Bottoming? is possible, but not probable for a while, but what we are seeing is fear that in more free markets would be a good indicator of an approaching bottom if we fall about 6% after the high. But now too much news is driving things. The post is likely right that restricted shorting may have a something to do with the VIX behavior. I suspect that this event wears itself out by the end of the October with some kind of a relief rally into year end.

2008 Oct 06 01:59 PM

[Brian Bober:]

Right now the Nasdaq is down over 8%. To me this looks like capitulation. I have added to a couple long positions today, but my concern is that hedge fund withdraws / deleveraging could send this market down another 20%. I agree with Whidbey that we will see a bottom this year. It’ll be a wild ride…

2008 Oct 06 02:54 PM

[bds231:]

I have been wondering the same thing -- how much are short restrictions driving the VIX? But if you look at a longer-term chart, the behavior of the VIX isn't all that different from 1998. Obviously the rest of the world is in a very different state, but perhaps this behavior isn't so out of the ordinary. Has anyone seen any data on how the short restrictions could be affecting the VIX?

2008 Oct 06 04:06 PM

[drierp:]

Option market makers are allowed to short.. They weren't for the very first day of this new rule, but that stipulation was rescinded over that weekend. The remaining factor is the ultra high VIX, and resulting high IV in nearly every stock. So, while there still are market makers in all the available listed option contracts, there spreads are 2-3x what we'd consider "normal"..

2008 Oct 06 06:46 PM