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Ask Trader Guy: Bad Quotes & Unamerican Shorting Techniques

October 1, 2010
flash crash shorting stocks
Fredrik Broden

Q: Hey, Trader Guy! How come the options quotes stunk during the “flash crash"?

A: Anyone watching quotes during the “flash crash” on May 6 saw the bid/ask spreads of options widen out enough to drive a truck through. That made it harder to execute trades at fair value, because you didn't really know where fair value was! The reason the market makers did this is that, contrary to popular opinion, they are not all-knowing market prognosticators. Option market makers typically don't take a lot of directional (delta) risk. Let's say an order comes in to sell calls. As a market maker, you'd buy those calls and sell stock to hedge them—which is the key. If the option market maker sees a stock with a tight bid/ask spread and a lot of trading volume around the current price, he can make his bid/ask spreads tight, too, because he knows he can reliably execute his stock hedge. But in the flash crash, individual stocks were dropping sharply, and the confusion made their bid/ask spreads wider. The option market makers responded by widening out their spreads because they didn't feel they could hedge the risk of their option trades. They needed more “edge” when they bought on their bids or sold at their ask prices because they might get a lousy fill on their stock hedge. From their perspective, they were just trying to protect themselves.

Q: Hey, Trader Guy! My doc says I should walk my dog to lose weight, but my dog hates me! Help!

A: I shudder to think what caused your dog to feel so negatively about you, his supposed master. But trading can be an efficient way to burn calories. Nervously bouncing your legs, ultra-fast mouse clicks, and alternating fist “pumps” with spins on your office chair from bell to bell will get your body moving, and maybe even draw your dog closer to you out of pity.

Q: Hey, Trader Guy! Grandma says shorting is un-American. She ain't wrong, is she?

A: Let's face it, shorting is betting the stock is not going to do well, which means the company isn't doing well, which means employees aren't doing well, etc. That's sort of negative. (If you're not in the know, selling a stock you don't own is known as “shorting. “) But while a short stock position does have theoretical unlimited risk, it isn't creating fake shares out of thin air, as some would have you believe. No, short selling is a speculative activity, just like buying stock. Active trading adds liquidity to the markets, which means all-American capitalists can get in and out of a position at a fair value quickly, and gives them confidence in their ability to manage their risk. It's also important to the process of “price discovery,” or figuring out what the market value of a particular security is. That's something that was sorely missing in the mortgage debacle.

Without the ability to short stock, you could only buy shares from someone who's closing out their long position. That could be mighty tempting to a dodgy corporate exec who can make claims to pump up the stock price and sell the stock at an inflated price before the truth gets out. Savvy short sellers can enforce a certain market discipline, which is as American as apple pie.

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