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Stockoptions | trade
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Short
Selling and Option Prices
Regulations allow market
makers to short sell without borrowing stock, and the transactions of
a major options market maker show that in most hard-to-borrow
situations, it chooses not to borrow and instead fails to deliver
stock to its buyers. Some of the value of failing passes through to
option prices: when failing is cheaper than borrowing, the relation
between borrowing costs and option prices is significantly weaker. The
remaining value is profit to the market maker, and its ability to
profit despite the usual competition between market makers appears to
result from a cost advantage of larger market makers at failing. |
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The market for short exposure in the
United States clears differently from the market for long exposure.
This difference has attracted considerable recent interest from both
the SEC and market participants who frequently short-sell or whose
stock is sold short. The interest is in both the economics of clearing
and in the pricing of the affected assets, which could be high or
inefficient.
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Short sales are usually accomplished
through equity loans. The short-seller borrows shares from an equity
lender which he delivers to the buyer. This debt of shares to the
lender gives him short exposure going forward. But there is another
way to create the same exposure: by failing to deliver the shares. If
the short-seller delivers nothing to the buyer, thereby incurring a
debt of shares to the buyer, this also gives him short exposure going
forward. This alternative moves the risk that the short-seller does
not repay his debt from the equity lender to the buyer, but just as
equity lenders have a mechanism for ensuring performance, i.e.
collateral, so does the buyer. The clearing corporation intermediating
the trade takes margin and marks it to market, thereby defending
buyers against their sellers' non-performance. If equity loans are
expensive, unavailable, or unreliable, as research shows they can be
then this alternative appears desirable, to short sellers if not to
buyers. But considering the market rules that bind short sales to
equity loans, how is it feasible?
The answer, we show, lies in the special
access to delivery fails that option market-makers enjoy. Traders are
generally obliged to locate shares to borrow before shorting, but
those engaged in bona-fide hedging of market-making activity are
exempt from this requirement. So unlike traders in general, a market
maker can short sell without having located shares to borrow. If he
does not locate shares to borrow then he fails to deliver, someone on
the other side fails to receive, and therefore retains the purchase
price, and the clearing corporation starts taking margin. While it
lasts, this arrangement is effectively an equity loan from the buyer
to the seller at a zero rebate. But whether it lasts depends on the
reaction of the trader being failed to. If a buyer does not get his
shares then he can demand them, in which case a short-seller who
failed is bought in: he must go buy the shares and hand them over. If
that short-seller wants to maintain his short exposure he must short
again, so this demand increases his shorting cost by this roundtrip
transactions cost. Thus, the cost of failing to deliver is the cost of
a zero-rebate equity loan plus the expected incidence of buy-in costs.
If this incidence is low enough, then failing is a valuable
alternative to borrowing the harder-to-borrow stocks. |
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Sources: Wikipedia, FCIC, SEC and other public sources.
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