Not every trader could have just hedged out the risk of a blowup. that is becuase derivatives are a zero sum game. For every trader who purchased the out of the money call, someone sold it. Therefore that person is now responsible for unlimited downside.

Exactly. And if you can't hedge at a reasonable price then you shouldn't make the trade in the first place. Also, if the call seller is covered then he only has a small downside.

Exactly. But let's take it a step further. Once the call seller covers himself (by buying stock in proportion to the delta of the option), he is essentially causing someone else to be short it as well. The unlimited downside is now passed to him. You can see how this just continues to propagate.

The point is that in any situation where shorting occurs, and therefore an excess amount of stock is floating, there is a non hedgeable unlimited downside risk that SOMEONE has to bear. Whether you pass it off in option or stock form is not relevant. Not everyone can hedge unlimited downside. Proper rules try to make sure these artificial squeezes do not happen, so as not to discourage short sellers (who are extremely, extremely important).

Now, that isn't to say that VW should be forced to reveal their position. It is not a trivial question what is the optimal way to stop this kind of thing. But it's important to discourage this activity where people deliberately accumulate shares to squeeze shorts. No economic value is created in this type of activity, just a transfer of wealth, whereas shorting serves a very important economic function.

That's not usually how it works. Most covered calls are sold by investors who already own the stock and want to juice it for some extra return. They're not going out and buying more, so the unlimited downside simply doesn't exist.

I still fail to see the problem with discouraging short sellers from making stupid unhedged speculative bets.

Actually, what you said is not how it works at all. Most covered calls are in the end, handled by wall street dealers who hedge their deltas with short sales (trust me about this). Retail investors that do covered calls do own the stock, but the net effect is not what you described, it is significantly more complicated. (by the way, the transaction you describe is equivalent to selling a put)

Without closing out the short sales that were done, usually there is always unlimited downside to at least ONE player in this transaction. Why is this intuitive? Abstract for a second. Treat the short sale as a contract, which it is, where you agree that you have to buy some object back in the future in return for a FIXED dollar amount now. If you assume that object (a stock in this case) can go up to an arbitrarily high price, then you always have unlimited downside as long as this contract is in effect.

The point is even if you disallow these artificial short squeezes, you are STILL discouraging "stupid speculative bets", becuase the price can go up naturally (when the thesis of betting against the stock is economically wrong). These are the right times for it to happen, and in fact happens all the time without a volkswagen type squeeze. The point about short squeezes is that someone can make a "smart speculative bet" (which society as a whole needs people to do) but still get blown up for non economic reasons.

Thanks for clarifying that. I didn't realize that Wall Street dealers would be stupid enough to take on what's effectively an infinite risk. I guess I shouldn't have been surprised given how many have blown themselves up lately.

But I think my original point remains valid. As long as short sellers buy sufficient options to hedge their positions, and those options are only sold by investors who actually own the stock, then no one is exposed to unlimited downside. And I fail to see how any trade that carries unlimited downside could ever be considered a "smart speculative bet" from any standpoint, regardless of whether it's economically right or wrong.

Effectively infinite risk? So you think a regulatory agency in the US will allow prices of a stock, say, GE to reach an unbounded number and still require settlement in derivative contracts to this? And I would not be as quick as you are in calling a professional stupid for doing something that any professor of finance would tell you is important for smooth functioning of capital markets.

You seem to just not grasp the magnitude of what you assume people should do in this crazy option proposal. It is not unusual for a stock to have a 25% short interest. That means a quarter of the shares are sold short. So you are saying a quarter of shareholders should sell calls to every short seller who wants to hedge? What if most shareholders do not want to sell options, and not give up the upside in doing so (indeed, there is a tradeoff in "juicing" your return, you lose the upside). In fact, most do not, so this is entirely impractical of course.

The whole point is with proper regulation that prevents the case of a squeeze or errant prices that are not sound, you prevent the "unlimited" downside (if a company ever becomes infinitely valuable, we will have other more interesting issues to deal with). This happens all the time--exchanges can cancel trades done at what are called "obvious error" prices. Regulation effectively clips the tail, which is why dealers have no problem shorting shares to ensure liquid markets.