US short sale rule may both help, hurt options trade

CHICAGO, July 16 (Reuters) - A clampdown on short selling will drive more investors to use options as another way to make bearish bets but it has also created a headache for options market makers that could prevent them from meeting the new demand.

An emergency rule introduced by the U.S. Securities and Exchange Commission will limit certain types of short selling in 19 major financial companies, including all the major investment banks. It will go into effect on July 21 and last through July 29 but it could be extended.

"We already see a real spike in option volume in the financial names as more investors speculate or hedge in this volatile sector," said Peter Bottini, executive vice president for trading at online brokerage optionsXpress Inc.

The new rule could hurt option market markers as it potentially diminishes liquidity and raises risk premiums.

That is because when options market makers sell puts they typically hedge their exposure by shorting the stock.

So if they are limited in how they can short the stock, then their ability to provide liquidity by selling puts would be hampered.

"These regulations can greatly limit the ability for legitimate options market-makers to provide needed liquidity at a time when transparent liquidity of listed products should be encouraged, not the opposite," Bottini said.

The emergency rule would require a short seller to borrow the securities before executing the sale. It would not allow traders or investors to sell stock that has not yet been borrowed even if they can clearly indicate where they can get hold of it.

The SEC is still discussing whether to make an exemption for option market makers. "It's under discussion with market participants," said SEC spokesman John Nester.

The Philadelphia Stock Exchange, whose acquisition by Nasdaq OMX Group (NDAQ.O) is expected to close within days, said on Wednesday it is asking the SEC for exemptive relief from the "pre borrow requirement."

"In terms of the effect on the options markets, we believe options market liquidity will diminish if options market makers are not exempt from the SEC's order," PHLX Chief Executive Meyer "Sandy" Frucker said in a statement.

Other U.S. options exchanges, such as the Chicago Board Options Exchange and the International Securities Exchange, owned by Deutsche Boerse (DB1Gn.DE), will also be affected by the rule change.

"If the SEC prevents option market makers from selling short in order to hedge their options trade, liquidity and market depth will be severely impacted," said Al Greenberg, head options trader at broker-dealer BNY ConvergEx Group.

Short sellers arrange to borrow shares they consider overvalued and sell them in hopes of making a profit when the price drops.

Equity puts allow investors to sell the stock at a preset price within a specified time period while a call enables them to buy the stock at a given price and time.

"This is a two-edged sword," said Scott Fullman, director of derivative strategy at broker-dealer WJB Capital Group.

"The new rule should create either a greater demand for put purchases from investors or a desire to sell calls. But on option market makers this inhibits their ability to hedge and therefore, will result in higher risk premiums on put options due to a lack of liquidity," Fullman said.

VOLUME INCREASE

For years speculators, professional traders and some mom and pop investors have been using a variety of option strategies as effective methods to trade the short side of the market.

If more short sellers move into the options market, already booming volume is expected to increase.

"If investors can not short stock they will turn to a viable alternative, which would be buying puts, put spreads or selling calls," said Joe Kinahan, chief derivatives strategist at online brokerage thinkorswim Inc.

All of these are bearish to neutral strategies and could be profitable if the underlying security declines in price.

One simple play to protect an existing stock position or to speculate on stock weakness is to buy a put option.

A put is a way of participating in a downward price change in the stock and would have similar benefits as shorting stock without having to be involved in the borrowing of the shares to satisfy the short sale regulations, said Herb Kurlan, chief executive of Vtrader Pro, an online trading firm.

Selling a call is another strategy. The objective in the sale of the call is for the stock to close below the strike price at expiration.

"People are going to turn to the options markets which have the function of providing investors the ability to go long or short stock through the use of calls and puts," Kurlan said. (Reporting by Doris Frankel; Editing by Gary Hill)