Option Investor
Trader's Corner

The Deep Freeze

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When my Dallas area trading group met, one frequent topic of conversation was "What could change that could make our types of trades unworkable?" We believed in being prepared. Since most of us committed much of our trading capital to income-producing options trades such as condors, calendars, butterflies and double diagonals, we discussed scenarios such as volatility levels that dropped so low that no premium was available. Never, ever did we discuss what almost happened several weeks ago. The story that began unfolding the week of September 15 is such a good illustration of how the options markets function that it provides the basis for a discussion of those workings.

On September 19, the SEC announced a temporary emergency action banning short selling in a list of 799 financial companies. This followed a September 17 ruling against naked short selling. That previous release had already alarmed some participants in the options market. The SEC had taken the stunning step of eliminating an exemption that options market makers had previously enjoyed. The SEC stated, "The Commission approved a final rule to eliminate the options market maker exception from the close-out requirement of Rule 203(b)(3) in Regulation SHO. This rule change also becomes effective at 12:01 a.m. ET on Thursday, September 18, 2008.

As a result, options market makers will be treated in the same way as all other market participants, and required to abide by the hard T+3 closeout requirements that effectively ban naked short selling." (Release 2008-204)

Options market makers suddenly found themselves exposed to massive risks with little time provided for them to adjust positions. Because these actions were being taken on option-expiration week, some leeway was given, with the September 19 order not to go into effect until the Monday after option expiration week.

Why could the options market makers--and traders in the convertible bond/preferred markets, too--be adversely impacted? When explaining the likely impact in a September 19 video of "CBOE Options Report with Doctor J," John Najarian called options market markers "risk transfer vehicles." Najarian explained that an options market maker must hedge his or her risk or else that market maker is reduced to the status of "a bookie taking a bet." Options market makers don't tend to last long if they don't know how to manage risk, Dan Sheridan, another frequent CBOE webinar presenter and a former market maker himself, has often noted.

Options market makers often hedge by buying or shorting stock. For example, Najarian explained, if a retail trader or institution wants to buy puts, in most cases, the market maker creates a synthetic put by buying a call and selling stock. The market maker's goal is to neutralize the market maker's delta and other risks, with delta risks being the risks that are incurred because of price movement. If an options market maker is long too many deltas and the markets move down, that options market maker's portfolio's losses mount quickly.

Writing as a guest commentator for RealMoney, Michael Kao, CEO and portfolio manager of Akanthos Capital Management explained the way that traders in the convertible bond/preferred markets must also hedge. He said that "its main participants are arbitrageurs who require the ability to short out their equity exposures for bona fide hedging purposes."

That was the problem that week of September 15 when the SEC changed the rules with its September 17 and 19 rulings. The SEC's ruling that no shorts would be allowed in an ever-expanding list of stocks took away the ability of those convertible bond/preferred market traders and options market makers to engage in "bona fide hedging" actions. Options market makers were being asked to assume massive risks to provide an options market without an effective means of hedging that risk.

These weren't men, women or firms seeking to drive stocks lower for personal benefit, but rather people and firms trying to avoid becoming Najarian's "bookie taking a bet." While some market watchers dismissed concerns about the viability of the options market, some important operators in the options market didn't. After these rulings, William J. Brodsky, Chairman and CEO of the CBOE, certainly didn't. In a Friday September 19 letter, he called the measures "draconian." He warned, "Investors rely on a deep and liquid options marketplace in which to safely hedge and to transfer risk in times of market turmoil, yet this action will severely compromise the ability of market makers to make markets. Liquidity in the affected stocks will suffer to the extent that market makers are hampered, and--absent relief--market makers will be hamstrung." He went on warn of the "serious ramifications for the reliability of the options market and for the efficiency of our capital markets overall."

His warnings weren't exaggerated. Already that Friday, September 19, a Dow Jones article had noted that several market making firms had avowed to stop trading options in the financials covered by the SEC's no-shorts ruling. In another CBOE video produced on September 19, Dominic Salvino of Group One Trading warned that "A lot of the markets are frozen up." He said, "If you pull up your screen, you'll see numbers, but it's not so clear what those numbers mean any more." He saw "very little" volume in options paper, saying, "The markets are extremely wide because the market makers are stuck in positions where they can't hedge themselves, so they're not willing to make markets." He said that information on options prices and volatility measures should take those numbers with the proverbial grain of salt.

He and Najarian both said that options market makers might eventually find some mechanism to hedge. Najarian said it was still possible with small positions when the market makers might "still trade on strike against another and trade puts that way," but he warned that wouldn't work with big positions. If a large order came in, the people in the pits "would scramble like crazy, because they would have to hit the S&P 500 futures."

Both Najarian and Salvino warned traders to expect very wide spreads on options come that next Monday, September 22. Some options traders were already noting widening spreads on Friday, although other factors may have been involved, too. With markets moving in huge ranges, it was difficult to ascertain whether the spreads had widened due to the increasing volatility or whether the increasing volatility and subsequent widening spreads were due to the changes going on in the markets prompted by the new rulings.

The CBOE's chairman and CEO wasn't the only person assailing the SEC with entreaties to reconsider. As a result, on September 21, the SEC issued the "Statement of SEC Division of Trading and Markets Regarding Technical Amendments to Short Sale Order." That amendment was made to "ensure the continued smooth operation of orderly markets." That was accomplished by the SEC's new decision to "keep in place the exception contained in the original order for short selling related directly to bona fide market making in derivatives, including over-the-counter swaps." The SEC tacked on a requirement that Najarian was to conclude required market makers to be psychic ("The Options Report with Doctor J," CBOE, September 22). That rule required that "for new positions, a market maker may not sell short if the market maker knows a customer or counterparty is increasing an economic net short position in the shares of the Included Financial Firm."

Market makers were saved, but they'd been scalded by various actions taken during that week. So had the traders in the convertible bond/preferred markets, Kao claimed.

Fascinating, isn't it, to learn how close we all came to unintended consequences that could have undermined the health of the options markets. What's the message for us? For now, options prices on some underlyings do appear to have widened. Salvino warned that "the bid/ask spread, as wide as it is now, it's tripled their [retail traders'] transaction costs. Instead of paying $0.20 on the bid/ask spread, they have to pay $0.60. That means they have to be awfully right."

Therefore, until things settle down, your options trades should be the results of the best trading setups you can find. This is no time for iffy trades. Market makers were willing to shut down completely rather than accept too much risk, and we retail traders should take our cue from them.

We should take the cue in more than our short-term options trades, too. We should consider the way that options market makers try to hedge against as many risks as they can: delta risks due to changes in price, theta risks due to the march of time and vega risks due to volatility changes. Perhaps it's time for us to educate ourselves about such risks in our portfolios and see what we can do to ameliorate them.

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