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A Terrible Idea

By Chris | September 19, 2008

The SEC bans the short-selling of financial stocks. This is a sad day. Fear and politics triumph over individual freedom and sound policy.

Arnold Kling offers a primer on short-selling and why stock prices can fall even if no one is “shorting.”

Tyler Cowen notes that investors are still able to short the exchange traded fund XLF. In other words, traders can a short basket of financial companies, they just can’t short any individual companies.

The options markets for these stocks are still operating. It occurred to me that you could still short stocks synthetically by purchasing a put and selling a call. However, if the call is exercised, you would become short the stock…which is illegal. Does anyone know how the options market functions under these conditions?

Topics: Economics, Law, Markets, Uncategorized | 10 Comments »

10 Responses to “A Terrible Idea”

  1. Mark R Says:
    September 20th, 2008 at 7:54 am

    AP, fellow economics grad student (and derivatives trader) in the UK here … I’m sure you know that puts reserve the right to sell a stock at a certain strike price. The strategy calls for one to be ‘short’ the stock by purchasing the put contract; however, they’re not borrowing shares to sell, which is what short selling is. Buying a put essentially means you’re purchasing shares at a certain price that someone has already purchased and is selling at that strike price. You can also sell a put (e.g., short puts), but again, this is not borrowing shares. Remember, derivatives, such as options are contracts b/t a buyer and a seller. Puts involve a trader borrowing shares at a certain price and waiting for the price to go down so that the shares can be bought at a lower price; the difference between the price the shares were borrowed at and the purchased price is profit (minus transaction costs, of course).

    I agree with you … it’s a sad day to see this kind of shotty regulation. This will not have beneficial long-term effects for the markets.

    Cheers,

    Mark

  2. Mark R Says:
    September 20th, 2008 at 7:55 am

    Sorry … I said “AP” above … I meant to direct the note to “AE” (Aspring Economist). Enjoy the blog. -Mark

  3. Chris Says:
    September 20th, 2008 at 11:58 am

    Mark…thanks for the comments. I have done a little derivatives trading as well, but it has been a few years. I understand that purchasing the put will not result in the actual borrowing of shares to sell. However, a synthetic short requires the simultaneous purchase of a put and sale of a call at the same strike price. A call is the right to buy the stock at a certain price (explaining for those who might not know). If I sell a call and the price of a stock goes up, the owner of the call will have the ability to exercise the option to purchase the stock at the strike price. If I don’t already own the stock, my broker would normally borrow the stock from someone else and make me go short on the stock. I guess in an environment where shorting is illegal, my broker would just force me to buy shares at the market price immediately to cover any calls exercised against me.

  4. Mark R Says:
    September 20th, 2008 at 7:24 pm

    Chris, you’re exactly right. In this scenario, you would be limited on any effective hedging and you’d just have to eat the increased costs when the share price goes up. Which is my main problem with restricting/eliminating shorts … this greatly limits the hedging potential for traders, so you will see many statarb, riskarb and other quant funds be hit hard by these changes. I wrote about this a little today, as did David Merkel at Aleph Blog. You’re going to see a lot of hedge funds suffer greatly from restricting shorts.

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