Abstract
In this study, we investigate the effects of stock short-sale constraints on options trading by exploiting two US Securities and Exchange Commission rule changes under Regulation SHO: Rule 203 (locate and close-out requirements) and Rule 202T (temporary removal of short-sale price tests). We find that stock short selling activities decrease (increase) significantly after Rule 203 (Rule 202T) implementation, supporting the validity of Rule 203 (Rule 202T) as an exogenous increase (decrease) in short-sale constraints. Options volume increases significantly after Rule 203 went into effect and the result is more pronounced among firms with lower levels of institutional ownership and smaller options bid-ask spreads. Therefore, the evidence from Rule 203 suggests that investors may use options as substitutes for stock short sales when short selling is less feasible or more costly due to the locate and delivery requirements. In contrast, we find no significant change in the options trading volume of pilot stocks during the pilot program of Rule 202T. Overall, our results indicate that the impact of short-sale constraints on options trading varies with the types of constraints affected.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
The impact of short-sale constraints on options trading depends on whether and how investors (demand side) as well as options market makers (supply side) are affected by the constraints. On the one hand, the demand-side channel focuses on the substitutability between stock short-selling and options trading. When stock short selling becomes expensive, establishing bearish positions in the options markets (such as buying puts or selling calls) can be an alternative choice for investors, leading to an increase in the demand of options (Diamond and Verrecchia 1987; Easley et al. 1998; Johnson and So 2012; Lin and Lu 2015). On the other hand, the supply-side channel emphasizes the complementarity between stock short selling and options trading. When investors take bearish positions in the options markets, options market makers need to hedge their positions by short selling the underlying stocks. Consequently, an increase in the market makers’ hedging costs due to tighter short-sale constraints would reduce the supply of options (Battalio and Schultz 2011; Grundy et al. 2012; Stratmann and Welborn 2013). Therefore, when the demand (supply) side dominates the supply (demand) side, high short-sale costs will lead to higher (lower) options trading volume.
Rule 203 and Rule 202T took effect at different time points, which provides us with two non-overlapping windows to investigate their effects separately.
The fail-to-deliver typically occurs three business days after the naked short sale due to the “T+3” settlement used in the US Boni (2006) finds that prior to Regulation SHO, a substantial fraction of issues (42 % of listed stocks and 47 % of unlisted stocks) had persistent fails-to-deliver of five days or more and these long-lived cases of “fail-to-deliver” were more likely to occur when stocks were expensive to borrow. This is consistent with the fact that equity and options market makers strategically fail to deliver shares that are expensive or impossible to borrow (Evans et al. 2009).
As initially adopted, Rule 203 included two major exceptions to the close-out requirement: the “grandfather” provision and the “options market maker” exception, both of which were subsequently eliminated after the end of our sample period.
In September 2008, the SEC issued a short-sale ban prohibiting the short selling of US financial stocks. With respect to banned stocks during the ban, investors could no longer take short positions. Options market makers could only sell short as part of bona fide market making and hedging activities.
Previous research shows that short sellers can receive better prices as a result of the short-sale price test (Albert et al. 1997). However, the tick test and bid test restrict the ability of short sellers to demand liquidity even in rising markets. This results in execution delays and lower fill rates (Alexander and Peterson 1999).
Subsequent to the pilot program of Rule 202T, on July 6, 2007, the SEC eliminated short-sale price tests for all exchange-listed stocks. The decision to eliminate all short-sale price tests prompted a huge backlash from managers and politicians. In response to this pressure, the SEC partially reversed course and restored a modified uptick rule (price tests are triggered when a security’s price declines by 10 % or more from the previous day’s closing price) on February 24, 2010.
Prior to the implementation of Regulation SHO, SROs had enacted several rules designed to prevent abusive naked short selling practices and fails-to-deliver. However, the SEC considered these rules as inadequate to prevent abusive short selling and extended fails-to-deliver.
Rule 203(c)(6) defines “threshold securities” as the securities of publicly traded and reporting issuers in which: (1) for five consecutive settlement days have aggregate fails-to-deliver at a registered clearing agency of 10,000 shares or more; (2) the volume of fails in a security is equal to at least one-half of one percent of the reported total shares outstanding in the security; and (3) the security is included on a SRO list identifying securities that exceed specified fail levels.
Bona fide market making does not include activity that is related to speculative selling strategies or investment purposes of the broker-dealer or is disproportionate to the usual market making patterns or practices of the broker-dealer in that security. In addition, when a market maker posts continually at or near the best offer, but does not also post at or near the best bid, the market maker’s activities would not generally qualify as bona fide market making for purposes of the exception. Further, bona fide market making does not include transactions whereby a market maker enters into an arrangement with another broker-dealer or customer in an attempt to use the market maker’s exception for the purpose of avoiding compliance with Rule 203 by the other broker-dealer or customer.
Short interest data are on a monthly basis. Daily short-sale volume data are not available before year 2005.
132/998 is 13.2 %, where 998 is the mean value of daily call options volume in the 3-month period before the implementation of Rule 203.
128/588 is 21.8 %, where 588 is the mean value of daily put options volume in the 3-month period before the implementation of Rule 203.
Boni (2006) documents that the likelihood of persistent fails-to-deliver (a proxy for naked short selling) decreases with institutional ownership.
References
Albert, R. L., Smaby, T. R., & Robison, H. D. (1997). Short selling and trading abuses on NASDAQ. Financial Service Review, 6(1), 27–39.
Alexander, G. J., & Peterson, M. A. (1999). Short selling on the New York Stock Exchange and the effects of the uptick rule. Journal of Financial Intermediation, 8(1), 90–116.
Alexander, G. J., & Peterson, M. A. (2008). The effect of price tests on trader behavior and market quality: An analysis of Reg SHO. Journal of Financial Markets, 11(1), 84–111.
Angel, J.J. (1997). Short selling on the NYSE. Unpublished manuscript, Georgetown University.
Battalio, R., & Schultz, P. (2011). Regulatory uncertainty and market liquidity: The 2008 short sale ban’s impact on equity option markets. The Journal of Finance, 66(6), 2013–2053.
Boni, L. (2006). Strategic delivery failures in U.S. equity markets. Journal of Financial Markets, 9(1), 1–26.
Chakravarty, S., Gulen, H., & Mayhew, S. (2004). Informed trading in stock and option markets. The Journal of Finance, 59(3), 1235–1258.
Chen, J., Hong, H., & Stein, J. C. (2002). Breadth of ownership and stock returns. Journal of Financial Economics, 66(2), 171–205.
D’Avolio, G. (2002). The market for borrowing stock. Journal of Financial Economics, 66(2), 271–306.
Diamond, D. W., & Verrecchia, R. E. (1987). Constraints on short-selling and asset price adjustment to private information. Journal of Financial Economics, 18(2), 277–311.
Diether, K. B., Lee, K. H., & Werner, I. M. (2009). It’s SHO time! Short-sale price tests and market quality. The Journal of Finance, 64(1), 37–73.
Easley, D., O’Hara, M., & Srinivas, P. S. (1998). Option volume and stock prices: Evidence on where informed traders trade. The Journal of Finance, 53(2), 431–465.
Evans, R. B., Geczy, C. C., Musto, D. K., & Reed, A. V. (2009). Failure is an option: Impediments to short selling and options prices. Review of Financial Studies, 22(5), 1955–1980.
Geczy, C. C., Musto, D. K., & Reed, A. V. (2002). Stocks are special too: An analysis of the equity lending market. Journal of Financial Economics, 66(2), 241–269.
Govindaraj, S., Li, Y., & Zhao, C. (2015). The effect of option transaction costs on informed trading in the options market around earnings announcements. Working paper.
Grundy, B. D., Lim, B., & Verwijmeren, P. (2012). Do option markets undo restrictions on short sales? Evidence from the 2008 short-sale ban. Journal of Financial Economics, 106(2), 331–348.
Hirshleifer, D., Teoh, S. H., & Yu, J. J. (2011). Short arbitrage, return asymmetry, and the accrual anomaly. Review of Financial Studies, 24(7), 2429–2461.
Johnson, T. L., & So, E. C. (2012). The option to stock volume ratio and future returns. Journal of Financial Economics, 106(2), 262–286.
Jones, C. M., & Lamont, O. A. (2002). Short-sale constraints and stock returns. Journal of Financial Economics, 66(2), 207–239.
Lamont, O. A. (2012). Go down fighting: Short sellers vs. firms. Review of Asset Pricing Studies, 2(1), 1–30.
Lin, T. C., & Lu, X. (2015). How do short-sale costs affect put options trading? Evidence from separating hedging and speculative shorting demands. Review of Finance, forthcoming.
McCormick, T., & Reilly, L. (1996). The economic impact of the NASDAQ short-sale rule. NASDAQ Economic Study. Working paper.
Nagel, S. (2005). Short sales, institutional investors and the cross-section of stock returns. Journal of Financial Economics, 78(2), 277–309.
Saffi, P. A., & Sigurdsson, K. (2011). Price efficiency and short selling. Review of Financial Studies, 24(3), 821–852.
Stratmann, T., & Welborn, J. W. (2013). The options market maker exception to SEC Regulation SHO. Journal of Financial Markets, 16(2), 195–226.
US Securities and Exchange Commission (2007). Economic analysis of the short-sale price restrictions under the regulation SHO pilot. Office of Economic Analysis, US Securities and Exchange Commission.
Author information
Authors and Affiliations
Corresponding author
Appendix
Appendix
See Table 11.
Rights and permissions
About this article
Cite this article
Li, Y., Zhao, C. & Zhong, Z. Migrate or not? The effects of regulation SHO on options trading activities. Rev Deriv Res 19, 113–146 (2016). https://doi.org/10.1007/s11147-015-9117-4
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11147-015-9117-4