The Impact of Short Sale Bans on Option Trading Activity: Evidence from the Financial Crisis of 2007-2009 and its Aftermath

Abstract: In the second half of 2008, the financial turmoil reached its peak. The situation was characterized by declining markets and intense speculations on the default of financial institutions. Financial regulators around the world responded by banning short sales of stocks. In most cases, however, the bans did not restrict trading in options. In this study, we use an international panel of options and stocks from 10 countries that adopted bans on short sales at some point in time from January 1, 2008 through February 28, 2011 to examine whether short sellers attempted to circumvent the bans by migrating to the option markets. More specifically, we do so by studying the impact of the bans on option trading activity. We find evidence that the short sale bans were associated with (i) an increase in option trading volume and open interest for both put options and call options, especially for options with high trading volume, and (ii) a decrease of the fraction of overall option trading volume that originates from put options, especially for options on U.S. stocks. Furthermore, the results indicate that bans on naked short sales were accompanied by an increase in option trading activity, whereas the estimated impact of bans on all short sales (both naked and covered short sales) is more ambiguous, especially for put options. Finally, our findings suggest that the bans increased the demand for call options more than the demand for put options. However, various subsample analyses and robustness tests indicate that the adoption of the bans is endogenous, and hence it is hard to assign the observed effects to an attempt by short sellers to circumvent the bans.