Do Option Markets Mitigate Short-Sales Constraints?

Abstract

Short-sales transactions are costly and can complicate the price efficiency of a stock due to their unique mechanism. Unlike traditional stock purchases, which occur over an exchange and are relatively costless, short-sales occur over-the-counter and require a lending process that can cause price to deviate away from fundamental value. Option markets, on the other hand, offer an exchange-based and loan-free method of initiating a short position on a firm. In my thesis, I demonstrate that option markets, to an extent, mitigate the transaction costs of short-sales. Moreover, I show that option markets are particularly effective at mitigating these costs when option liquidity is also adequately present. Finally, I find that options do not necessarily do a good job at mitigating costs when it comes to shorting high beta firms, while options seem to perform particularly well at mitigating costs when it comes to shorting small market capitalization firms. I argue that these results imply that options resolve short-sales constraints better when constraints are driven by a shortage in shorting supply, which often occurs with small market capitalization firms, rather than by an excess in shorting demand, which often occurs with high beta firms.