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I understand that illegal naked shorting can lead to FTDs since same share can be loaned out and shorted multiple times. This can lead to a situation where >100% of a stock's float is shorted (Ref: How can GameStop be short 140% of float?)

Can the same thing happen on steroids with selling naked calls which is perfectly legal?

Here's how I think it would play out, and kindly correct my understanding of the mechanism if it's flawed:

  1. AFAIK a fixed amount of call/put contracts is not "issued" by anybody the same way that a company decides to issue shares and dilute its own holding.

  2. Call contracts come into existence and get destroyed dynamically whenever a buyer and a seller agree on a strike, expiration, and premium.

  3. Theoretically if an option seller decides to sell a lot of OTM naked call contracts (without delta hedging), the stock price goes up, buyers of the call options decide to exercise, does that lead to FTDs?

  4. If this happens, will the stock act like a derivative of options? What market mechanisms exist to prevent this?

Thanks

maverik
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    I don't see why you wouldn't be able to have call options for more than 100% of the shares. The sellers of those options are probably about to go bankrupt once WSB finds out, of course. As for "can the same thing happen on steroids", I can't figure out what "the same thing" refers to. – user253751 Mar 02 '21 at 17:17
  • There's no limit to the number of options that can be created other than position limits per person (and those numbers are vary large). – Bob Baerker Mar 03 '21 at 04:06
  • The tem 'counterfeit shares' is incorrect and very misleading. First, calls don't 'create' shares, they create the right to buy them; and second, any such share is a normal, valid share. There is nothing 'counterfeit' anywhere in any relation. – Aganju Mar 07 '21 at 01:19

2 Answers2

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AFAIK a fixed amount of call/put contracts is not "issued" by anybody the same way that a company decides to issue shares and dilute its own holding.

That is correct. There's is no limit to the number of options that can be created as long as you have the required margin to support the naked short option position. However, brokers tend to raise the margin requirement in situations like GameStop.

Call contracts come into existence and get destroyed dynamically whenever a buyer and a seller agree on a strike, expiration, and premium.

Yes and no. Contracts come into existence when both parties take opening positions. Contracts are terminated (destroyed) when both parties take closing positions. If one party is opening and the other is closing then contracts are just changing hands. What's germane to your question is that the selling of the call increases open interest thereby affecting the option market maker's need to add long delta (buy shares) in order to remain hedged.

Theoretically if an option seller decides to sell a lot of OTM naked call contracts (without delta hedging), the stock price goes up, buyers of the call options decide to exercise, does that lead to FTDs?

Assignment of a short call results in a short position in the underlying. In and of itself that doesn't create the FTD. FTD is a conscious decision by the trader not to borrow the stock, resulting in a naked short (equity). It's no different than naked shorting of the stock without acquisition of shares for delivery (FTD).

What market mechanisms exist to prevent this?

The broker is supposed to borrow shares for the newly opened short equity position and close it down if borrowable shares are not available. Evidently, it's not a foolproof system since there are frequent complaints about the illegal practice of naked shorting of equities.

Bob Baerker
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  • Thank you for the explanation. My thesis is that currently GME stock is a derivative of its options market since the stock price never spends much time between strikes. I'm not sure brokers can borrow shares when the price moves quickly, otherwise gamma squeezes wouldn't be a thing. What would happen if they can't close the position either? Are market makers next in line? – maverik Mar 02 '21 at 20:54
  • My thesis is that currently GME stock is a derivative of its options market since the stock price never spends much time between strikes. I don't know what that means. Options are derivatives that track the price of the underlying, regardless of the underlying's price. I also don't follow the gamma squeeze statement. Because of their need to hedge short calls, option market makers must buy more and more stock in order to remain delta hedged as the underlying rises. That buying (gamma squeeze) contributes to the speed and strength of the short squeeze. – Bob Baerker Mar 02 '21 at 21:16
  • Brokers can borrow shares as long as there are lenders willing to lend shares. – Bob Baerker Mar 02 '21 at 21:16
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To sell a naked call, you need to have margin, and a lot of it.
To get in an area of even 50% of the stocks, you need to have a significant chunk of money, far out of reach for normal investors.

Aganju
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  • There are several margin formulas for selling naked equity calls and the margin requirement is the highest one of them. As a loose generalization, the margin requirement is in the vicinity of 20% of the value of the underlying (size of premium, distance to strike, OTM amount, etc. cause the amount to vary). Since the margin for shorting the underlying is 50% (not applicable for leveraged ETFs), the amount of money needed to sell a naked call is far less. I don't follow the logic of rather than sell a naked call (shorting), instead, you could/should buy the company right away. – Bob Baerker Mar 02 '21 at 19:46
  • I wouldn't sell a naked call if I were bullish. That's clearly a bearish/neutral move. – maverik Mar 02 '21 at 20:46
  • I see your point, @BobBaerker - I was trying to impress that you need a lot of money to cover selling 50% short calls. I took a wrong example for the explanation. – Aganju Mar 02 '21 at 23:00
  • "My thesis is that currently GME stock is a derivative of its options market since the stock price never spends much time between strikes" I also do not know what that means. :O – Fattie Mar 03 '21 at 00:25
  • I mean that usual efficient market and price discovery principles are not setting GME share price. There are enough counterfeit shares floating that prices are disconnected from fundamentals and solely driven by actions of options MM. – maverik Mar 06 '21 at 22:37
  • ^ @BobBaerker could it be that Open Interest has become the independent variable and stock price over time the dependent variable? – maverik Mar 06 '21 at 22:39
  • @maverik I don't think that you can distill the GME situation down to being solely driven by actions of options MM. There are multiple other players here: equity buyers, option buyers and sellers, shorting, illegal shorting, redditors, hedge funds, etc. As for Open Interest has become the independent variable and stock price over time the dependent variable?, I have no clue what that means. – Bob Baerker Mar 06 '21 at 23:41