by Mark S. Longo 10/09/08
A Chilling Effect
The table reveals the chilling effect that the short selling ban had on options volume in September.
The month started off with a bang as concern mounted about the credit crisis. However, options volume dropped precipitously when the short-selling ban was implemented. This reduced level of volume remained in effect for the rest of the month despite an environment that was incredibly favorable to options trading.
No single data point on the table illustrates this better than Sept. 29.
On that day the market experienced the single largest point decline in history. It is also the day that the CBOE Volatility Index (VIX) reached a new all-time high of 46.74.
With all of these factors aligned, Sept. 29 should have been the busiest day in the history of the options market. With the exception of few outliers, it's difficult to think of an environment that was more conducive to options volume. However, the expected surge in volume never materialized.
In fact, total volume on Sept. 29 amounted to little more than half of the volume from Sept. 18. That just happens to be the last full trading session before the short-selling ban went into effect. The intent of the ban was to put the brakes on a turbulent market, but it is difficult to believe this is what the SEC intended.
Land of Confusion
A ban on short selling in financial securities would negatively impact options volume even under the best circumstances. However, the SEC's implementation of the ban was surprisingly clumsy and shortsighted, particularly when it came to the options market. This made the overall impact of the ban far more severe than anyone anticipated or intended.
The blanket nature of the original ban, the ever-changing list of banned securities and the extremely vague nature of the market maker exception created an atmosphere of crippling confusion. As the ban wore on, questions began flooding into The Options Insider from retail investors and professionals alike:
Is it legal to purchase put options in the banned stocks?
Can customers exercise puts to establish net short positions in banned financial stocks?
How can market makers determine the intent and positions of the customers on the other sides of their trades?
What would happen if a customer established a short position in a particular stock only to find out the next day that it had been added to the banned list?
These questions and many others created an air of uncertainty that drastically curtailed overall options volume. Under these dire circumstances, many options market makers decided that discretion was the better part of valor. Some threatened not to participate while others simply widened their bid/ask spreads until they were no longer relevant to the NBBO.
This resulted in higher option premiums and reduced liquidity throughout the options market. This reduced liquidity was a particular concern in equity and index put options as customers scrambled to hedge stock portfolios against dramatic swings in the market.
Is the Worst Over?
The headlines are accurate. September was indeed an amazing month for the options market. However, it's difficult not to view the entire month as a wasted opportunity. In times of crisis, the options market functions as a critical safety valve for the financial world. By inadvertently crippling the options market, the SEC deprived investors of that safety valve when it was needed most.
More By This Expert
The result was increased uncertainty and reduced liquidity, two factors that exacerbated an already dangerous situation. When academics and historians look back on September 2008, many will speculate as to how well the options market could have performed if the SEC hadn't stood in its way.
Thankfully, the end of the short selling ban seems to have eliminated much of the confusion plaguing options traders and customers. 25,164,830 contracts changed hands in the first full session after the termination date was announced. It is the highest daily volume since Sept. 18. Hopefully, it is also a sign that the worst is behind us. Autumn may be on the horizon, but the chill seems to have left the options market.
Mark S. Longo is the founder of The Options Insider.com. To learn more about him, read his bio.
This article originally appeared on The Options Insider Web site.
Ken Trester
Stocks may look cheap now, but are they really? There's a better way to make money in this market.
Investor Jiu-jitsu – The 88% Strategy Credit Spreads
This strategy is all about using the market's momentum against itself to take advantage of leverage and pile on the profits month after month.
5 Ways to Profit From Volatility
The crazy volatility spike has some people shying away from trading, and they're missing out. Find out how to use volatility to your advantage.
Volatility: The Option Buyer's Secret Weapon
Many experts claim that buying options is a sucker's game, but they don't understand the rules.
Diversify Your Options Universe
Diversity makes the world go 'round, and the same is true of your portfolio.
