US short sale rule may both help, hurt options trade

By Doris Frankel

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.