Short Sales and Regulation SHO

Mechanics and risk

The seller's firm borrows the shares — from its own inventory, from another customer's margined securities, or from another firm's stock loan desk — and delivers them to the buyer. The buyer is a real owner with real shares; nothing about the transaction is notional from their side.

Short sales must be effected in a margin account. A cash account cannot support them, because the position creates an obligation rather than an asset. The proceeds of the sale are held as a credit and are not available to the customer.

The risk profile is asymmetric and it is worth stating in the same terms as the options module. Maximum gain is the sale proceeds less commissions, achieved if the stock goes to zero — bounded. Maximum loss is unlimited. The short seller is also obliged to pay any dividends declared on the borrowed stock to the lender, since the true owner is entitled to them, and can be bought in — forced to cover — if the lender recalls the shares and the firm cannot borrow elsewhere. Hard-to-borrow securities carry borrowing costs that can be substantial.

A customer whose short position moves against them faces a margin call on a position that keeps growing, which is the practical form the unlimited risk takes. Lesson 6.2's answer applies: buying a call caps the price at which the short seller can be forced to cover, and is the standard hedge.

Marking the order

Rule 200(g) of Regulation SHO requires a broker-dealer to mark every sell order in an equity security as long, short, or short exempt.

An order may be marked long only if the seller is deemed to own the security under the rule and either the security to be delivered is in the firm's physical possession or control, or it is reasonably expected to be there no later than settlement.

Ownership under Regulation SHO is broader than holding certificates. A person is deemed to own a security if they hold it, have purchased it or entered into an unconditional contract to purchase it, own a security convertible into or exchangeable for it and have tendered for conversion, hold an option to purchase it and have exercised, or hold a warrant or right and have exercised. Crucially, a person is deemed to own only to the extent they have a net long position — a customer long 500 shares and short 300 has a net long position of 200, and only that much may be sold long.

Short exempt is a narrow marking used only where the price test provisions of Rule 201 permit it.

Mismarking a sale is a serious matter. It defeats the locate requirement, it distorts the short interest data the market relies on, and it is a records violation on top of a Regulation SHO violation.

Locate and close-out

Rule 203(b)(1) is the locate requirement, and it is the heart of Regulation SHO. A broker-dealer may not accept a short sale order in an equity security from another person, or effect one for its own account, unless it has borrowed the security or entered into a bona fide arrangement to borrow it, or has reasonable grounds to believe the security can be borrowed so that it can be delivered when delivery is due — and has documented that compliance.

That documentation requirement is what turns the locate from an assertion into an auditable fact. A firm cannot claim it believed the stock could be borrowed; it must be able to show what it relied on.

There are exceptions. A broker-dealer accepting an order from another registered broker-dealer that is itself required to comply does not duplicate the locate. A sale of a security the person is deemed to own, which they intend to deliver once restrictions are removed, is excepted — but if the security has not been delivered within thirty-five days after the trade date, the firm must borrow or close out. And market makers effecting short sales in connection with bona fide market making activities are excepted, because a market maker quoting a two-sided market must be able to sell into a buy order without a prior locate.

Rule 204 handles what happens when delivery fails anyway. A clearing agency participant with a fail to deliver position on a long or short sale must close it out by borrowing or purchasing securities of like kind and quantity no later than the beginning of regular trading hours on the settlement day following the settlement date. Three variations: a fail resulting from a long sale gets until the beginning of regular trading hours on the third consecutive settlement day after settlement date; a fail from a sale of a deemed-owned security awaiting removal of restrictions gets until the thirty-fifth consecutive calendar day after the trade date; and a fail attributable to bona fide market making gets an extended period.

A threshold security is one with a persistent, substantial level of fails to deliver, published daily by the exchanges. FINRA Rule 4320 imposes delivery requirements on short sales in non-reporting threshold securities.

The price test and legitimate uses

The old uptick rule — which permitted a short sale only on a price higher than the last different price — was eliminated in 2007. What replaced it in 2010 is a circuit breaker.

Under Rule 201, if a covered security's price falls 10 percent or more from the prior day's closing price, a restriction is triggered for the remainder of that day and the following day. While it is in effect, the security may be sold short only at a price above the current national best bid. The design permits short selling to continue but prevents short sellers from hitting the bid while a security is already falling sharply.

Short selling has legitimate uses the exam expects you to be able to name, and it is worth being able to state them because the practice is publicly controversial.

Speculation on a decline, which is the obvious one, and the one with unlimited risk.

Hedging. An investor holding a portfolio or a convertible security can short the underlying to neutralize part of the exposure. A short against the box — shorting a security the investor already owns — locks in a price, though the tax consequences of doing so are governed by the constructive sale rules and it no longer defers gain the way it once did.

Arbitrage. Buying a convertible bond and shorting the underlying stock to capture a mispricing between them; or buying a security in one market and shorting it in another.

Market making. A market maker's inventory goes short in the ordinary course of filling customer buy orders, which is why the bona fide market making exceptions exist.

And securities lending sits underneath all of it. Firms lend securities to each other for a fee, hard-to-borrow securities cost more to borrow, and a customer's margin securities may be lent under the hypothecation agreement they signed — a fact that lesson 9.5 returns to, since customers rarely realise their shares are the ones being borrowed.