"Black Monday Redux" Sparks Historic VIX Rally, But Short Selling Ban Stifles Options Market

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Black Monday Redux
The 778 point (nearly 7%) plunge in the Dow Jones Industrial Average sent shock waves throughout the financial world. However, despite that historic decline, Black Monday Redux was not a record day for the options market.

Total options volume on Monday amounted to only 17.8 million contracts. That total does not rank in the overall top ten for daily options volume. In fact, Black Monday Redux doesn't even rank in the top ten for the month of September. So far, ten trading days have had volume over 17.8 million contracts this month.

Granted, September has been a historic month for options volume. The 30 million contracts that changed hands on September 18th marked the single busiest day in options history. That total eclipsed the previous record of 26.6 million contracts that was set on September 17th. With two record volume days in a single week, September was on track to be the busiest month in options history.

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SEC Breaks The Options Market
However, the SEC's reactionary ban on short selling in financial stocks also had the unintended consequence of breaking the options market (see Banning Short Selling Could Have Disastrous Consequences For The Options Market). With options market makers unable to hedge many of their positions, options volume slowed to a trickle. Although the SEC has since implemented an exception for options market makers, the chilling effect of that ban continues to impact overall volume.

During times of great duress, two-way trading disappears in the optionsmarket as customers line up to buy puts and sell calls. However, theSEC has included the following language in the market maker exception:

"market makers may not sell short if the market maker knows a customer or counterparty is increasing an economic net short position"

This clause has prevented much of the speculative and hedging activity that occurs in put options during extreme market conditions. It has also prevented the options market from challenging the volume records that it set earlier this month.

VIX Surges To Record Highs
The historic drop in the broad market sent the CBOE Volatility Index (VIX) soaring to historic new heights. The VIX surged over 39% to an intra-day high of 48.4 as fears over the bailout continued to mount.

The index finally ended the day up 34.5% to 46.74. That is a new all-time high for the index. The previous high in the VIX occurred on October 8, 1998 when the index closed at 45.74.

The chilling effect of the short selling ban spilled over into VIX options as well. Despite record movement in the underlying index, only 170,000 VIX contracts changed hands on Monday. That total may seem impressive, but it is far short of the record 426,961 contracts that changed hands on September 16th.

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