5 ms·

> If you take away short selling, you take away many other healthy components of functioning markets. You won't have functioning options markets for example, be

> If you take away short selling, you take away many other healthy components of functioning markets. You won't have functioning options markets for example, because market makers can't hedge their positions I'd say this isn't actually true. You'd hedge your short deltas and let the long deltas ride, prefer to sell delta to flatten risk (in other words charge more when selling puts and pay less when buying calls to compensate for P&L variance), and expect put-call disparities to level out in a slightly different manner. You could also sell well-correlated futures to hedge, or just trade combos and pass the risk off to someone else. Empirically, many of the hard to borrow names are the most well-traded in the options world. When people can't sell short, they buy puts and pass the risk off to a market-maker. Specifically about what I said about put-call parity: In the status quo, if puts are more expensive than stocks, you generally sell a put, sell 100 shares of stock, and buy a call. In the hypothetical world where you can't sell short, if you don't already have long shares then you can't take advantage of the inefficiency. So, put implied vol would trade over, and large banks and other dealers who are already long stock would have an advantage over small shops that don't already have a long shares position. The only real difference is that options markets would be less liquid, wider and less efficient.

JumpCrisscross 8y ago
> The only real difference is that options markets would be less liquid, wider and less efficient Which raises costs for new share issuances (by making underwriting riskier), convertible debt (by making it more expensive to hedge the stock component), certain other flavours of debt, acquisitions, et cetera.
- totalZero 8y ago
  And yet you'd still have a functioning option market, which is the point in question. You don't have to hedge delta in short shares of the underlier in order to deal options. You can hedge out using your long shares, and then do the remainder in a correlated instrument or leave it without a hedge. For a pure market maker who simply buys and sells to earn spread, hedging is a means of managing P&L variance and protecting oneself against negative selection bias. Similarly, you also don't have to hedge converts in options. I'm not sure I understand your point about underwriting. Due to regulations, options don't start trading until several days after an IPO. Options on spinoffs tend to list more quickly, but are delayed as well. Secondary issuances have the advantage of already seeing where the market priced the stock, and are generally small, so there's no need to have a tight options market to hedge them.
  - JumpCrisscross 8y ago
    > you'd still have a functioning option market Most of the time. Professional options market makers would be degraded. (As an aside, you'd also spawn systemic risks. Increased market-making risk favors small shops; access to inventory large. To bridge the gap, shorting would be replicated–more expensively, less transparently, and more riskily–through banks swapping their inventory to funds writing options. Add in your suggestion that hedging rely on historical correlations and you have a recipe for a preventable crisis.) On underwriting, secondary issuances for seasoned issuers don't require options markets. But it reduces risk. That, in turn, reduces the cost of market access. Australia's short-seeing ban "reduced trading activity, increased bid and ask spreads and increased intraday volatility" while providing "no evidence for lasting price support from the restrictions" [1]. It's a stupid idea that raises costs for everyone while sounding cute to the naive. [1] https://epublications.bond.edu.au/cgi/viewcontent.cgi?referer=https://www.google.com/&httpsredir=1&article=1532&context=business_pubs https://epublications.bond.edu.au/cgi/viewcontent.cgi?refere...
aaavl2821 8y ago
I think my statement about not having functioning options markets was stronger than I intended. I just meant you'd have way less liquidity, sometimes so little liquidity that you might as well not have a market Could you elaborate on your point about hard to borrow options being the most widely traded? I'm not a derivatives person but was at a biotech fund and briefly looked at those options markets, and the bid ask spreads were ridiculous for many names to the point where it was almost pointless to even put in an order. Liquidity was super light as well
- totalZero 8y ago
  I've seen this many times as an options market-maker: A short-seller fund can't get borrow (which is a requirement for short selling) on a name it's already short, so it can't add to the short position. Thus, they call a bank and buy put options. The bank makes a price that incorporates (charges for) the borrow risk, usually because (A) the bank has an easier time locating borrow and gets a better price, (B) the bank trader/desk has a larger tolerance for P&L swings and can thus take the other side of the trade and hedge the position slowly or not at all, or (C) the bank has better market access and can trade combos (synthetic shares) against a different institution that has stock or a better borrow rate. As a general rule, there's options activity for names that are very volatile. This doesn't always show up on the open interest count, because many firms trade OTC contracts that don't have the same clearinghouse protections as exchange-listed option contracts. Option bid/ask spread being wide don't necessarily mean that volatility itself is illiquid. There could be large size on both bid and offer, with every dealer under the sun making a market, but the carry rate spread is wide, and that widens the option price. For example, the put offer will be based on the short rate, and the put bid will be based on the long rate, so if these two rates are divergent (as is the case when a name is hard to borrow), then the spread will be wide even if both sides are priced with the same implied volatility. BTW even if screens show little more than a 100-lot, a bank will make a price on a much larger block of options. You won't know where liquidity is without quoting dealers. An option market could show a bid/ask that's 2 dollars wide with 200 contracts on either side, but a market maker may make you a two-way price that's 30 cents wide for 10,000 contracts. Depends on a lot of factors (who's the client, what's the position, does the market maker know the name and have a view, what are the catalysts, why is the screen market so wide, etc)

JumpCrisscross 8y ago

> The only real difference is that options markets would be less liquid, wider and less efficient Which raises costs for new share issuances (by making underwriting riskier), convertible debt (by making it more expensive to hedge the stock component), certain other flavours of debt, acquisitions, et cetera.

totalZero 8y ago
And yet you'd still have a functioning option market, which is the point in question. You don't have to hedge delta in short shares of the underlier in order to deal options. You can hedge out using your long shares, and then do the remainder in a correlated instrument or leave it without a hedge. For a pure market maker who simply buys and sells to earn spread, hedging is a means of managing P&L variance and protecting oneself against negative selection bias. Similarly, you also don't have to hedge converts in options. I'm not sure I understand your point about underwriting. Due to regulations, options don't start trading until several days after an IPO. Options on spinoffs tend to list more quickly, but are delayed as well. Secondary issuances have the advantage of already seeing where the market priced the stock, and are generally small, so there's no need to have a tight options market to hedge them.
- JumpCrisscross 8y ago
  > you'd still have a functioning option market Most of the time. Professional options market makers would be degraded. (As an aside, you'd also spawn systemic risks. Increased market-making risk favors small shops; access to inventory large. To bridge the gap, shorting would be replicated–more expensively, less transparently, and more riskily–through banks swapping their inventory to funds writing options. Add in your suggestion that hedging rely on historical correlations and you have a recipe for a preventable crisis.) On underwriting, secondary issuances for seasoned issuers don't require options markets. But it reduces risk. That, in turn, reduces the cost of market access. Australia's short-seeing ban "reduced trading activity, increased bid and ask spreads and increased intraday volatility" while providing "no evidence for lasting price support from the restrictions" [1]. It's a stupid idea that raises costs for everyone while sounding cute to the naive. [1] https://epublications.bond.edu.au/cgi/viewcontent.cgi?referer=https://www.google.com/&httpsredir=1&article=1532&context=business_pubs https://epublications.bond.edu.au/cgi/viewcontent.cgi?refere...

aaavl2821 8y ago

I think my statement about not having functioning options markets was stronger than I intended. I just meant you'd have way less liquidity, sometimes so little liquidity that you might as well not have a market Could you elaborate on your point about hard to borrow options being the most widely traded? I'm not a derivatives person but was at a biotech fund and briefly looked at those options markets, and the bid ask spreads were ridiculous for many names to the point where it was almost pointless to even put in an order. Liquidity was super light as well

totalZero 8y ago
I've seen this many times as an options market-maker: A short-seller fund can't get borrow (which is a requirement for short selling) on a name it's already short, so it can't add to the short position. Thus, they call a bank and buy put options. The bank makes a price that incorporates (charges for) the borrow risk, usually because (A) the bank has an easier time locating borrow and gets a better price, (B) the bank trader/desk has a larger tolerance for P&L swings and can thus take the other side of the trade and hedge the position slowly or not at all, or (C) the bank has better market access and can trade combos (synthetic shares) against a different institution that has stock or a better borrow rate. As a general rule, there's options activity for names that are very volatile. This doesn't always show up on the open interest count, because many firms trade OTC contracts that don't have the same clearinghouse protections as exchange-listed option contracts. Option bid/ask spread being wide don't necessarily mean that volatility itself is illiquid. There could be large size on both bid and offer, with every dealer under the sun making a market, but the carry rate spread is wide, and that widens the option price. For example, the put offer will be based on the short rate, and the put bid will be based on the long rate, so if these two rates are divergent (as is the case when a name is hard to borrow), then the spread will be wide even if both sides are priced with the same implied volatility. BTW even if screens show little more than a 100-lot, a bank will make a price on a much larger block of options. You won't know where liquidity is without quoting dealers. An option market could show a bid/ask that's 2 dollars wide with 200 contracts on either side, but a market maker may make you a two-way price that's 30 cents wide for 10,000 contracts. Depends on a lot of factors (who's the client, what's the position, does the market maker know the name and have a view, what are the catalysts, why is the screen market so wide, etc)