One For The Record Books
data: OCC

There has been a lot of talk about the explosion of options volume that took place in September. There certainly is a great deal to celebrate. Overall options volume amounted to 374,531,673 contracts last month. That is an incredible 84% jump from September 2007. The options market also set a new record for monthly volume, surpassing the old record from July by 2.3%. 

Equity options volume also set a new record in September. 341,301,652 equity option contracts changed hands last month. That is a nearly 87% increase from September 2007.

If that wasn't impressive enough, two new daily volume records were also set last month. More than 26 million contracts changed hands on September 17. That stunning total was immediately surpassed on September 18 when options volume exceeded 30 million contracts.

With so many new records on the books in September, the term "banner month" is an understatement of epic proportions. Unfortunately, the SEC had a surprise up its sleeve that would quickly send a chill throughout the world of options.

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Short Selling Ban Breaks the Options Market
Despite a flurry of new volume records, all was not rosy in the options market last month. When you dig beneath the surface of the volume numbers, the impact of the SEC's recent short selling ban comes into stark relief. In virtually every sense of the word, the SEC broke the options market in September (read "Black Monday Redux" Sparks Historic VIX Rally, But Short Selling Ban Stifles Options Market for more information).

There's no better way to illuminate this than by looking at the daily volume numbers from September:

September By the Numbers

DATE	OVERALL CONTRACT VOLUME
9/2	13,055,423
9/3	13,854,839
9/4	17,251,942
9/5	15,377,943
9/8	18,097,244
9/9	19,286,103
9/10	17,860,080
9/11	18,958,697
9/12	17,871,710
9/15	21,866,318
9/16	25,164,093
9/17	26,747,401 - New Daily Volume Record
9/18	30,034,196 - New Daily Volume Record
9/19	23,306,211 - Sept. Options Expiration, SEC Ban Goes Into Effect
9/22	13,690,202  - MM Exception, Volume Down 41% from 9/19
9/23	13,887,524
9/24	11,636,573
9/25	12,922,483
9/26	12,171,889
9/29	17,853,466  - Dow Drops 778 Points, VIX Surges 39%
9/30	14,073,463

Pre-Ban (9/2-9/19) Avg. Daily Volume = 19,909,442
Post-Ban (9/22-9/30) Avg. Daily Volume = 13,747,942

A Chilling Effect
The above table reveals the chilling effect that the short selling ban had on options volume in September.

The month started off with a bang as concern mounted over the credit crisis. However, options volume dropped precipitously when the short selling ban was implemented. This reduced level of volume remained in effect for the rest of the month despite an environment that was incredibly favorable to options trading.

No single data point on the table illustrates this better than September 29. On September 29, the market experienced the single largest point decline in history. It is also the day that the CBOE Volatility Index (VIX) reached a new all-time high of 46.74.

With all of these factors aligned, September 29 should have been the busiest day in the history of the options market. With the exception of few outliers, it's difficult to think of an environment that was more conducive to options volume. However, the expected surge in volume never materialized.

In fact, total volume on September 29 amounted to little more than half of the volume from September 18. That just happens to be the last full trading session before the short selling ban went into effect. The intent of the ban was to put the brakes on a turbulent market, but it is difficult to believe this is what the SEC intended.

Land Of Confusion
A ban on short selling in financial securities would negatively impact options volume even under the best circumstances. However, the SEC's implementation of the ban was surprisingly clumsy and shortsighted, particularly when it came to the options market. This made the overall impact of the ban far more severe than anyone anticipated or intended.

The blanket nature of the original ban, the ever-changing list of banned securities and the extremely vague nature of the market maker exception created an atmosphere of crippling confusion. As the ban wore on, questions began flooding into the Options Insider from retail investors and professionals alike:

• Is it legal to purchase put options in the banned stocks?
  
  
• Can customers exercise puts to establish net short positions in banned financial stocks?
  
  
• How can market makers determine the intent and positions of the customers on the other sides of their trades?
  
  
• What would happen if a customer established a short position in a particular stock only to find out the next day that it had been added to the banned list?
  

These questions and many others created an air of uncertainty that drastically curtailed overall options volume. Under these dire circumstances, many options market makers decided that discretion was the better part of valor. Some threatened not to participate while others simply widened their bid/ask spreads until they were no longer relevant to the NBBO.

This resulted in higher option premiums and reduced liquidity throughout the options market. This reduced liquidity was a particular concern in equity and index put options as customers scrambled to hedge stock portfolios against dramatic swings in the market.

The Worst Is Over?
The headlines are accurate. September was indeed an amazing month for the options market. However, it's difficult not to view the entire month as a wasted opportunity. In times of crisis, the options market functions as a critical safety valve for the financial world. By inadvertently crippling the options market, the SEC deprived investors of that safety valve when it was needed most.

The result was increased uncertainty and reduced liquidity, two factors that exacerbated an already dangerous situation. When academics and historians look back on September 2008, many will speculate as to how well the options market could have performed if the SEC hadn't stood in its way.

Thankfully, the upcoming end of the short selling ban seems to have eliminated much of the confusion plaguing options traders and customers. 25,164,830 contracts changed hands in the first full session after the termination date was announced. It is the highest daily volume since September 18. Hopefully, it is also a sign that the worst is behind us. Autumn may be on the horizon, but the chill seems to have left the options market.