SSRN-Options and the Bubble by Robert Battalio, Paul Schultz

Time to rewrite my class notes.....Like many people I have been telling my classes that at least a portion of the reason that Internet stocks were allowed to get so overpriced during the so-called bubble was that short-sale restrictions prevented investors from shorting the shares to drive down prices.

However, in their Options and the Bubble paper Robert Battalio and Paul Schultz show that even if there were short sale restrictions, the option market was efficient enough to allow investors to circumvent the short restrictions.

Unlike Ofek and Richardson (2003), Battalio and Schultz

"find few cases when synthetic and actual share prices diverge enough to appear to create arbitrage profits from short-selling. Indeed, the option and stock prices track each other so closely that we conclude short sale restrictions did not seem to have an important impact on Internet stocks." [emphasis mine]

They do this by showing that

"short sales of synthetic shares, formed by buying puts and writing
calls, are a viable alternative to selling actual shares short. For Internet stocks during the sample period, the expected proceeds from a synthetic short sale averaged about 99.5% of the expected proceeds from the short sale of actual shares. Even the hard-to-borrow stocks in our sample could be easily sold short synthetically, yielding proceeds that were on average only 0.6% less than the proceeds of an actual short-sale...."

Additionally, the option market was not just along for the ride, but a significant amount of information was being discovered via option markets. In the authors' words:

"We find that price discovery did take place in the options market during our
sample period. Moreover, we find that a larger portion of price discovery took place in the options market on days when the stock price declined."

So if we can't blame short sales restrictions, what caused the bubble? The authors conclude that investors simply did not know that the prices were too high:

"it was not obvious to them that Internet stocks were too high. They were trying to value companies in a new industry with unprecedented levels of recent growth. We academics, along with reporters and regulators, have the unfair advantage of hindsight."

Yet another very cool paper!!!

Cite:
Battalio, Robert H. and Schultz, Paul H., "Options and the Bubble" (March 2004). AFA 2005 Philadelphia Meetings; EFA 2004 Maastricht Meetings Paper No. 3081. http://ssrn.com/abstract=558543

BTW Yes I realize this is not the newest paper, but I just found it when doing class notes for the upcoming semester. So I decided that since I had not seen it before, maybe some of you had not either.