204 Ways to Lose Your Stock
Vol #167: February 22nd, 2024
Asset prices are waves that ebb, flow, and tsunami. The billion dollar question is knowing how much and when. This is why we price options.
Volatility models will balance the very recent past, with the long dated history. Weighted components for factors local and foreign attempt to calibrate the scales of the future. This is complicated, and framed in upper level maths. And that’s only for the vanilla contracts traded on the floor. Step it up a PhD when you introduce barriers, knock-outs, or worst-of combinations.
Most of the complexity of the model is centered around how to predict the likely range of outcomes. No matter how many conditions there are, the payout of a contract is based on where stock(s) sit at expiration. Cuneiform caveats for paths taken over the counter.
Since the only people that can predict the future of price movement are busy being endlessly pampered, the rest of us settle for probability exercises. Simply combine everything you know about this stock, all stocks, and all the things that affect stocks. Now what’s a fair price for this move?
But the simple input you carried over to the other side of a differential equation relies on the sourcing abilities of a handful of enforcers. Vol is nothing without a hedge, and stock loan is the underworld.
Borrows dress up in deal sleds and wrap a blue collar in Thinsulate, but this is concrete and shovels work. They’re here to throw fair value out the window, and take away your hedge. Whiffing on a fill is frustrating, and having to sell stock a dime lower makes the bought call more expensive, but at least you have a position.
Short sellers endure abuse from every type of market participant. But no one protests put buyers, or call sellers. Stock borrows are an obscenity, and these are much less messy ways to get short deltas. So dealers take the other side and sell the stock to hedge. The ability to provide a tight bid in MSFT calls, is predicated on the ability to short sell.
Most Microsoft shareholders aren’t worried about this, many of them are taking advantage of the 1.1% premium from 30 day, 30 delta calls. Neither are the shareholders of thousands of other “General Collateral” securities, letting short selling dealers borrow the shares is a fairly benign proposition.
A pure hedger will not impact the market beyond their implementation horizon. Flattening deltas hard or soft, it’s tedious work not driving the market against you. Every single transaction cost analysis I saw demonstrated post fill reversion. I promise you dealers aren’t short selling because they think stock is going down or have a personal vendetta against the CEO. (Looking at you, Overstock.)
Stock borrows for the general collateral securities pay roughly the risk free interest rate. Some brokers let individual traders opt in to their loan program and get a slice of the compensation. If you’re long a fully paid for stock, lending shares pays interest on something you were happy to own anyways.
Moving down the liquidity food chain, there are fewer and fewer shares available. A couple big put buyers quickly change the dynamics. Market makers aren’t the only ones looking for shares, outright shorts from institutions will also be putting pressure on the market.
One of the most frequent blocking factors for listing options relates to float. It’s easy to have a share price above a certain threshold and even hit daily trading volumes. But having 2000 non-insider shareholders can be a restrictive hurdle. If shares aren’t freely available, there can’t be a functioning options market.
As demand goes up, so do the rates. When something goes hard to borrow, short stock holders have to pay up. Mechanically, this hurts like a dividend. Short stock pays while long calls don’t receive. Minor adjustments here are like mispricing volatility. You sold a $12 straddle and stock moved $15.
When things get really messy is when there is no stock. #REF, can’t divide by 0. Trading mostly seems like bits and bytes moving across accounts, but when you peel back enough layers there’s a finite number of stock certificates. And even fewer of them are in the hands of people who want to give them to you. Directors and insiders, particularly of closely held companies, aren’t keen to let someone short their baby.
Due to the archaic timing of US settlement, it takes 2 full days from when you smashed the red button in REDI+ before anyone realizes this. Some anon on Instinet gave you dollars and you’re due to hand over shares. But you just have bought calls, no certificates. Time for the Stock Loan desk to open up the trunk.
Part of the good service that a clearing company does, is secure borrows for their clients. If market makers can’t sell short, they can’t pay clearing fees. Plus, being a gatekeeper to back room deals has its own edge.
Stock Loan at Merrill or Goldman or ABN is constantly on the phone with large holders to negotiate borrows. They’re squeezing Northern Trust to get a little bit more Biotech Inc, and well incentivized by the vig on a -90% borrow. Math meet mechanics.
Market makers can route orders to dozens of venues, but shopping around for stock loan is like negotiating the price on your in-flight cocktail. It’s a captive business, and clients don’t have too many choices. And forget about other ways of getting stock (e.g. SSFs or external borrows), clearing companies don’t like people horning in on their edge.
When there’s no stock to be had, at any rate, you’ve got a failure to deliver. Start the penalty box clock, and if you don’t bring the shares you promised, someone’s buying them for you.
The rules of short selling have morphed over the past two decades. Reg-SHO initially gave market makers a blanket exemption. Fairly quickly this was removed, and everyone played the 13 day game of chicken. If you were short stock in a threshold security, you hoped it would fall off the list before risk forced you to cover. Price would keep going up, but there was a chance enough other people bought back stock to take it off the list. If you can, draft one day behind the peloton.
The window has tightened significantly, and now it’s a settlement after settlement framework, i.e. t+4 according to Rule 204. If you don’t have a borrow, get ready for pain. Fortunately there’s a carve out for pre-fail credits, where if your position has already flopped back the other way you don’t get double dinged.
Market makers have dynamic positions, so they’re almost always trading the short end of the borrow curve. There are arrangements for long term borrows, but that’s now taking a bet on the direction of future orderflow. Who knows what tomorrow’s wheel brings?
Getting back stock is a slog. You’re not trading for edge, you’re treading water in a hurricane. Long calls are a blessing, while shorts are a curse. Deep delta punches get offset by your own written calls. It’s fairly likely that other market makers have the same position as you, and are also trawling the shallow end for any borrow available.
After all the warning signals, alarm bells, and written notices, the sheriff comes knocking. Oh to have the discretion of a buy in trader. The tape starts lighting up a little before 4pm ET, and no stock offer is too high. These are god candles, going straight through the heart of a poor short.
Now you’ve got long calls, and were handed back long deltas at a horrible fill price. All in a name that everyone is borrowing to sell short because they think it’s going to zero. If you want back on the merry go round, start selling stock again, just be sure to drop your call bids as fast as the market is giving you shorts.