Apparently, an extension of the ban is being mooted that would encompass a ban on short selling of all shares and, bizarrely, euro-denominated currency derivatives. Quite what the German authorities think they will gain from such market-disruptive nonsense is hard to fathom.
How might a ban on naked currency option short positions possibly work? Ignore, for a moment, the fact that it is at present only the Germans that are suggesting this and imagine that the ban is implemented globally.
Optionality is a strange beast: an option may have an underlying but the only way to truly hedge a short option is to buy an option with exactly the same strike and expiry. Under a short-selling ban, if a market-maker hasn’t got the required option on his book, he can’t sell it; and the customer will have extreme difficulty in buying one. The currency option market effectively disappears.
This outcome might be welcomed by Merkel and, although he has declined to impose such bans himself, by French president Nicolas Sarkozy. However, while the market might sometimes over-promote the ‘God’s work’ (© L. Blankfein) it is doing in facilitating world trade, we will be back in the Dark Ages of hedging if currency options are not available.