If they ban short-selling derivatives become the underlying

A reminder in the spirit of being attuned to seemingly far-fetched risks:

If short selling were restricted in any way, the value of puts relative to calls on the same strike increases in a put-call parity framework.

Another way to say this is being long stock is more valuable since only long sellers can sell. If puts increase relative to calls on the same strike, as they do when borrow costs increase, that is like a synthetic future on the stock trading at a discount to the stock price.

Similarly, being short futures vs being long index or SPY expresses the same bet. If futures start trading at a sustained discount to the cash index value it could also reflect an implied probability of short-selling restrictions being imposed.

If futures are trading at full carry and you think such a ban is possible it’s an asymmetric bet to put on conversions (ie short futures, long stock or for options short combos long stock).

Broadly speaking, the derivatives market becomes the underlying market. When the underlying market becomes encumbered do to technical frictions, derivatives are no longer just “derivatives”. The arbitrage mechanism is severed. The derivatives market becomes the home for price discovery.

I’ve seen this happen throughout my career. Just a few examples in addition to hard or impossible to borrow/short situations:

HYG becoming a liquid referendum on illiquid high-yield bond market
Cotton option synthetics continuing to trade even when the underlying futures are locked limit up (my trading claim to fame is selling the all-time nominal high in cotton in late 2011…it was an option synthetic around $2.25)
When a stock is halted, the premium or discount to any ETFs holding that stock computed using the halted stock’s “last” price before the halt implies the price the stock will open when it resumes trading. These situations were common during the dot-com heydey when stocks would be halted intra-day on pending news announcements.

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