SEC Follow Up Exhibits Part C SEC_OEA_FCIC_001760-2501

Reg SHO Pilot Report DRAFT 9/14/2006
Additionally, traders can avoid price restrictions by synthetically shorting in the option
market rather than shorting the stock. 12 To measure the extent to which price restrictions drive
short sellers to the option market, we compare option market trading activity for pilot and control
stocks. We find no evidence that short sale price restrictions in equities have an impact on
option trading or open interest. 13
Regardless of whether price restrictions have any substantive impact on overall market
liquidity or inhibit manipulation, they affect the ability of short sellers to demand liquidity by
getting prompt execution of market orders. For purely mechanical reasons, we would expect
price restrictions to affect the number of trades occurring on downticks vs upticks, and the
percentage of time the market is in an upbid or downbid state. For Listed Stocks, we find that
the application of the tick test results in significantly fewer than 50% of transactions occurring
on downticks or zero downticks, while trading is more balanced when the tick test does not
apply. For Nasdaq NM Stocks, we find that the percentage of time the market is in a downbid
state declines when the bid test is removed, suggesting that downbids occur more regularly when
the bid test applies.
To the extent that price restrictions inhibit the free movement of stock prices, they might
make markets less liquid. On the other hand, because short sellers can rarely execute against a
bid quotation, price restrictions force short sellers to act more like liquidity suppliers than
liquidity demanders. Therefore, removing them might decrease the perceived supply of
liquidity. To test whether price restrictions have a more general impact on liquidity or volatility,
we compare quoted and effective spreads, intraday volatility, and the daily price range across
12 A synthetic short position can be achieved by buying a put option and writing a corresponding call option in the
same security. The term synthetic refers the fact that you can replicate the payoffs of an equity short sale without
actually short selling the equity itself.
13 Open interest is the total number of options contracts that have not yet been closed or fulfilled by delivery.
Prepared by the Office of Economic Analysis 7
DRAFT