Government at its finest

I have quite a lot to say about this week’s events.  But my time is short (HA HA GET IT?) this weekend, and I think I have noticed something interesting about the short-sale ban, so the TARP will have to wait.

From the actual SEC order:

Similar to the Amended July Emergency Order, we are providing a limited exception for certain bona fide market makers. We believe this narrow exception is necessary because such market makers may need to facilitate customer orders in a fast moving market without possible delays associated with complying with the requirements of this Order.

For any particular security, a “bona fide market maker” is an entity that promises to provide both bid and ask prices at all times for that security.  (On the NYSE, market makers are called “specialists”.)  In order to do this without having a permanent (long) pool of stock, they must be allowed to hold short positions.  If you took this ability away, the liquidity would simply vanish, resulting in an even more volatile market.  What do I mean by that?  Well, imagine if you wanted to sell your stock and there were simply no bid at all…

So, the SEC has excepted market makers from the new rule, which is OK because they are registered and regulated and an important part of making the U.S. markets the most liquid and efficient in the world.

Trivial stuff, but I just wanted to make sure you know what a “market maker” is, why they are important, and how they are being given special treatment.  My real point involves the options market.

Like the stock market, the options market also has market makers who always provide both a bid and an ask for any option.  These market makers cannot (or rather, will not) perform their function unless they can remain “delta neutral”, which is options-speak describing a bag of instruments such that movement in the stock price either way does not affect the value of the bag.  For example, if they buy a call, they will also sell some of the underlying stock.

The most common options trades for retail investors are selling (covered) calls and buying “put protection” against stock they already own.  The most common market maker actions, therefore, are on the opposite side; i.e., buying calls and selling puts.  Both of these require selling stock to remain “delta neutral”, so options market makers are generally short the security underlying the option in which they are making a market.

Now, back to the SEC order:

Finally, to facilitate the expiration of options on September 20th, options market makers are excepted from the requirements of this Order until 11:59 p.m. on September 19th when selling short as part of bona fide market making and hedging activities related directly to bona fide market making in derivatives on the publicly traded securities of any Included Financial Firm.

In other words, the exception does not apply to options market makers starting on Monday.  I suspect this will have a (very) bad effect on the options market.  Hullo, what’s this on the Bloomberg?

“If they don’t fix it, there just won’t be an options market on Monday,” Steve Claussen, chief investment strategist at OptionsHouse LLC, the Chicago-based online brokerage unit of options trading firm PEAK6 Investments LP. “If they have an exemption for market-makers that they’re allowed to sell stock short, then they can provide a market in the options.”

And another this morning:

The SEC staff recommended making permanent an exemption for market makers who use short sales to hedge options transactions. The revision would release derivatives brokers from SEC rules aimed at halting manipulative trading after the fall of Lehman Brothers Holdings Inc. and American International Group Inc. …

“Either you had to change the rules or you had to halt options trading,” said Henry Schwartz, president of Trade Alert LLC, a New York-based provider of options market analytics.

Which is all well and good, except for one thing.  Do you know what happens if you simply sell a call and buy a put with the same strike price and expiration?  You get a synthetic short.  This has exactly the same risk / reward (i.e., cost / payoff) as shorting the stock.  So if the SEC extends the exception to options market makers, then starting Monday:

  1. You can sell a call and buy a put on (say) AIG
  2. The market maker on the other side of your trades will short the stock
  3. You will reap all profits and losses on that short, less the options spread

In other words, the net result will be that everybody can short the financials again simply by paying a small fee to the options market makers.

To grant this exception is to revoke the short-sale ban, transforming the whole thing from “hideous” to simply “humorous”. Now that’s the kind of government I have come to know and love.

Here’s hoping they do it.

Update

They did it.  Sort of.

2 comments to Government at its finest

  • foss

    Great analysis good enough to get me to stop lurking

    But with a limitless government backstop why short?
    The feds will buy the troubled assets at 50 cents on the dollar then buy senior preferred to make up the difference
    Yes it is dilutive but it is not the bullet to the head they have been using
    Shorts were using a death spiral model and it was almost like going long basically a very mild risk short position since all roads led to zero price. I hate this plan but it puts in an uncertain floor which makes shorting a risky move again.
    Famtastic work keep it up.

  • Yeah, the TARP is very good for the banks and very bad for the country. So the logical move here is probably long financials, short everything else.

    Except maybe AIG. If you think that one is still being run for the benefit of shareholders, there are some lobbyists you need to meet.

    I really, really have to run. I will get my full thoughts on the TARP up later this weekend.

    Thank you for the comments.

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