THE JOURNAL OF FINANCE
VOL. LXVI, NO. 6
Regulatory Uncertainty and Market Liquidity:The 2008 Short Sale Ban’s Impact on EquityOption Markets
ROBERT BATTALIO and PAUL SCHULTZ
We examine how the September 2008 short sale restrictions and the accompanying confusion and regulatory uncertainty impacted equity option markets. We ﬁnd thatthe short sale ban is associated with dramatically increased bid-ask spreads for op-tions on banned stocks. In addition, synthetic share prices for banned stocks becomesigniﬁcantly lower than actual share prices during the ban. We ﬁnd similar resultsfor synthetic share prices of hard-to-borrow stocks, suggesting that the dislocation inactual and synthetic share prices is attributable to the increased hedging costs foroptions on banned stocks during the short sale ban.
This ban is terrible for option market makers. It will kill options tradingbecause you cannot price options fairly. You cannot buy a call or sell a putand hedge them.
—Joe Kinahan, derivatives strategist at the Thinkorswim Group,September 19, 2008.
T THE END OF THE SUMMER
of 2008, as prices of commercial and investmentbank stocks plummeted, the Securities and Exchange Commission (SEC) cameunder intense political pressure to curb short selling of ﬁnancial stocks. Latein the day on September 17, 2008, the SEC moved to stop naked short selling
Battalio and Schultz are with the Mendoza College of Business, University of Notre Dame. Wethank an anonymous ﬁrm for providing the option data used in our analysis, the Options Clearing Corporation for providing early exercise and open interest data, S3 Matching Technologies andan anonymous retail broker for providing retail order and rebate rate data, and the ISE forproviding data on trades that open or close trading positions. We thank Al Lemon, Hang Li, andBillMcDonaldspeciﬁcallyandtheMendozaITgroupmoregenerallyfortheirhelpinprocessingtheOPRAdataandMargaretForsterforproddingustotakeonthisproject.WegratefullyacknowledgecommentsfromPeterBottini,ShaneCorwin,KarlDiether,MichaelDoherty,AmyEdwards,RobertJennings, Charles Jones, Carolyn Mitchell, Rob Neal, Jerry O’Connell, Gavin Rowe, Sophie Shive,JeffSoule,andRodTaylor;seminarparticipantsattheUniversityofNotreDame,theUniversityof Pittsburgh,theOhioStateUniversity,theUniversityofOklahoma,andtheUniversityofKentucky;and participants at the Federal Reserve Bank of Atlanta’s conference “Short Selling: Costs andBeneﬁts”; the IIROC-DeGroote 2010 Conference on Market Structure and Market Integrity; the2nd Annual RMA-UNC Academic Forum for Securities Lending Research; and the 2010 WesternFinance Association meetings.
See the October 7, 2008 Reuters News article by Doris Frankel titled “Short-sale ban worriesU.S. options markets.”