Short Selling Ban, Part III: Implications for Implied Volatility

Compromised markets create compromised data.

The impact of the short ban on the equity options market has been profound. There is debate surrounding the S&P level for Friday’s open that was used to calculate settlements given the fact that the final status of outlier prints on financial stocks from that morning is still up in the air. Meanwhile, bid ask spreads in some put series are wide enough to drive a truck through and the normally staid volatility levels for blue chips like GE are in the 40’s or higher.

When we say “volatility” we are talking about one of two things –either realized historical volatility or the volatility implied by option premiums. The VIX Index, the most commonly used barometer of market volatility, is a measure of the implied volatility of options on the S&P 500.

Implied volatility is calculated through a process of reverse engineering. Using a pricing formula such as Black Scholes, the premium for an option is used to derive the implied volatility level by backing out the known aspects (the maturity and strike price) as well as assumptions (the financing rate and hedge). These pricing formulas are all based on the assumption that a trader will be able to freely hedge the option exposure in the underlying market. The shorting ban leaves implied volatility calculations for those stocks heavily compromised by asymmetrical liquidity.

This may sound very abstract and irrelevant at first, but consider what a significant portion of equity trading volume is generated by quantitative managers who rely on implied volatility as an input for their modeling process. By changing the rules mid-game the SEC may be forcing these players to head for the sidelines.

Andrew Barber