Monday, September 29, 2008

Short selling and market liquidity - law of unintended consequences

A number of option market makers are going to stop making markets in banks stocks that have short selling restrictions, 799 names.The option market makers need to sell stock to lay-off risk when they are long calls. Without the ability to sell stock, you cannot structure hedges for your option book. You cannot make two-way markets if you have one leg of your hedging strategy taken away. For some the answer will be who cares, but at this time options are a critical source of liquidity. The short selling restriction also have hurt high frequency traders who add liquidity. When the market wants to go down, no amount of short selling restrictions will stop it.

Perhaps the better rule would have been to re-institute the uptick rule, or allowing short sales for market makers. This would have allowed for shorting but not a punishing raid on stocks where shorts could force down stocks.

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