August 11, 2007
Allowing a loophole for an options market maker simply gives the best and brightest a means to avoid the rule. There are many options strategies equivalent to shorting a stock (e.g. sell call, buy put). Essentially this allows traders a means to avoid the rule by routing the trade through the options desk, who can short the stock without scrutiny. It allows potentially abusive activities such as buying large numbers of puts, or selling large numbers of calls, which could drive the stock down and essentially create shares from the options desk.
Supply and demand for the underlying shares and the risk and incremental cost embedded in heavily shorted securities should be fully reflected in options prices. Under the current scheme, it is not, and option premiums are artificially low (especially puts for heavily shorted securities).
Finding shares, borrowing them, and potentially getting squeezed, are risks and costs that option traders bear and that shorts take on when they short a security. For options to be correctly priced, all parties must abide the same rules.
The change is unlikely to result in lower liquidity. Higher premiums on calls and puts will induce people to write covered calls on shares that they own, or write puts against cash. The market will equilibrate to one where the option premiums correctly reflect the supply, demand, liquidity, and risk of the underlying security.