Reg SHO and Options Markets: The Interplay of Equities and Derivatives

The Options Market: A Backdoor for Short Exposure

Regulation SHO is primarily focused on the equity markets, but it has a significant impact on the options markets as well. For traders who are looking to gain short exposure to a security, the options market can provide a number of alternatives to shorting the stock directly.

One of the most common ways to use options to create a synthetic short position is to buy a put option. A put option gives the holder the right, but not the obligation, to sell a security at a specified price within a specified timeframe. By buying a put option, a trader can profit from a decline in the price of the underlying security without having to go through the process of locating and borrowing the shares.

Another way to use options to create a synthetic short position is to sell a call option. A call option gives the holder the right, but not the obligation, to buy a security at a specified price within a specified timeframe. By selling a call option, a trader can profit from a decline in the price of the underlying security, but they also take on the risk of unlimited losses if the price of the security rises.

The Options Market Maker Exception

Regulation SHO includes a limited exception to the locate requirement for bona fide market makers. This exception is designed to allow market makers to facilitate customer orders in a fast-moving market without being subject to the delays that can be associated with the locate process.

However, the options market maker exception has been a source of controversy, with some critics arguing that it has been used to facilitate naked short selling. In 2008, the SEC eliminated the options market maker exception, but the debate over the role of market makers in the short selling process continues.

The Impact on Options Pricing

Regulation SHO can also have an impact on the pricing of options. When a security is hard-to-borrow, the cost of borrowing the shares can be passed on to the options market in the form of higher put prices and lower call prices. This is known as the 'put-call parity' relationship.

For options traders, this can create opportunities to profit from the pricing discrepancies between the equity and options markets. For example, a trader could use a 'reversal' or 'conversion' strategy to arbitrage the difference between the price of the underlying security and the price of a synthetic position created with options.