Panicky Option Traders Seek Relief From SEC's New Rule
The WSJ reports: The seven U.S. options exchanges are preparing to ask for an exemption from a new Securities and Exchange Commission rule aimed at slowing short-selling of stock in financial companies, people familiar with the effort said Wednesday.
By putting the kibosh on so-called naked short-selling in companies like Fannie Mae, Freddie Mac and Lehman Brothers, the SEC has complicated life for the market-makers in the options market.
Options market-makers routinely engage in short-selling to hedge positions they take with clients. The SEC’s July 15 decision disrupts that commonly used trading strategy and makes it more expensive to conduct business as usual.
“My book makes a market in nearly every name on [the SEC] list,” said Andy Schwarz, founder of AGS Specialist Partners. “This affects our book in a big way.”
Short sellers are betting that the price of a stock will fall. They do so by selling borrowed stock and then repaying the stock later, hopefully at a lower price. Some investors making such bets hoping to profit when a stock gets cheaper. Others, like options market makers, may merely be trying to offset the risk they take on when selling customers options that rise in value when stock prices fall.
Those in the latter camp have been caught up by the SEC’s effort to slow a tide of short selling that has swamped financial stocks and contributed to deep, confidence-sapping drops for shares of Fannie, Freddie and Lehman.
Existing SEC rules don’t allow naked short selling — shorting stock without ever borrowing it — but they do allow broker/dealers to sell stock short as long as they reasonably believe they can locate the needed shares and deliver them on time. Beginning Monday, short sellers will need to make formal arrangements to borrow the shares before selling them.
Schwarz knew the SEC’s decision was going to complicate matters as soon as he heard about it. He spent the good part of Wednesday morning on the phone with his clearing agent trying to make sure his market makers on the American Stock Exchange would be able to borrow stock before selling it short.
Schwarz and other market makers grease the wheels of the options market by taking the opposite side of buy and sell orders. If a customer wants to buy 100 options in Goldman Sachs, for example, his traders will “make a market” and sell them.
When doing so, market-makers often hedge the positions they take. If they sell put contracts, for example, they will turn around and sell stock in the same company. If they buy calls, they will buy stock.
The new SEC rule will make the process more costly, and market makers will pass those costs along to their clients.
“If a customer bought a put yesterday at $4, they might have to buy it today for $4.20,” Schwarz said.
The situation will get particularly messy if the SEC as contemplated expands the prohibition to cover even companies whose shares are less liquid, Schwarz says. In that case, the costs of borrowing increase. In that case, borrowing shares will become so costly or so complicated that market makers will either refuse to trade options in those companies or do so only at high prices.
“If market makers can’t hedge themselves,” Schwarz said, “they will be unable to sell puts and buy calls.”
Full Story: blogs.wsj.com
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