Tuesday, September 23, 2008

The mother of all short squeezes (2)

One of the remaining prime brokers sent the following out yesterday to its clients:
The SEC has imposed emergency rules for short sale and economically similar dealing in approximately 800 financial services companies. Part of the new rules impact options trading strategies that can lead to a short sale, even if temporarily. The following limitations on option trading have been put in place to conform to the SEC regulations.

(A1) purchase of call options and exercise of long call positions
(A2) sale of call options against an existing long stock position in a ratio less than or equal to 1 call per 100 shares
(A3) purchase and sale of put options
(A4) purchase of single stock futures

Not Allowed:
(NA1) exercise of puts that would lead to a short stock position
(NA2) selling uncovered calls or uncovered single stock futures (coverage via stock)
(NA3) selling long stock if so doing will expose an uncovered short call position

Please be aware that the actual rules and interpretations on the rule are being refined by the SEC on an ongoing basis.
In our original commentary on the short-selling restrictions Friday, we pointed out the impact the order would have on the market-making ability of ETF issuers. By the end of the day, the SEC had issued "technical amendments" to its original order (see the full text of theamended order). These include a specific exemption for ETF and ETN market-makers:
bona fide market making and hedging activity related directly to bona fide market making in exchange traded funds and exchange traded notes of which Covered Securities are a component.
The SEC has also extended the exemption for options market-makers for the duration of the emergency order, but included as a condition a virtually unenforceable requirement that market-makers not contribute to increasing their customers' net short positions in financial stocks..

What we saw yesterday in the markets -- a slow but deep slump, including in financial stocks, after Friday's manic short-covering rally, but with option implied volatility collapsing and thin volumes -- was a consequence of removing liquidity from a market in which an artificial price floor was set without inducing any real confidence or conviction in market participants. As long as no one is permitted to short financials, it will be hard to find real, committed buyers for them, confident that a bottom has been marked in their prices.

And with uncertainty around the nature of the hedging activities that are (or will remain) permissible, a host of ordinary -- that is, non-manipulative, bona fide -- trading practices will remain severely constrained.

In situations where options issuers are constrained, where prime brokers are limiting or banning options transactions, and where transactions costs for short sales of whatever kind (even as part of net long positions) are increased -- even if only because of the added time it takes to confirm that the sales are permissible -- we should expect strategies involving algorithmic and portfolio trading and hedging to be hit especially hard. And those strategies are major sources of liquidity.

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