On Friday August 9, 2013, the Securities and Exchange Commission issued a Risk Alert to help market participants detect and prevent options trading that circumvents an SEC short sale rule.
The SEC’s Office of Compliance Inspections and Examinations (OCIE) issued the alert after its examiners observed options trading strategies that appeared to evade certain requirements of the short-sale rule. The alert describes and warns of the strategies used by some customers, broker-dealers and clearing firms, summarizes related enforcement actions, and makes suggestions regarding practices found to be effective in detecting and preventing trading intended to evade Regulation SHO.
Regulation SHO tightened requirements for short sales, which involve the selling of securities not already owned, usually by the borrowing of securities. Short sellers profit from price declines by replacing borrowed securities at a lower price. Under RegSHO, short sellers who fail to deliver securities after the settlement date are required to close out their position immediately, unless they qualify as a market maker. The trading strategies observed by the OCIE staff may give the impression of satisfying the Regulation SHO “closeout requirement,” while in effect evading it.
In addition, the Risk Alert describes activities that the staff has observed that may indicate an attempt to circumvent Regulation SHO. These include:
Trading exclusively or excessively in hard-to-borrow securities or threshold list securities, or in near-term listed options on such securities
Large short positions in hard-to-borrow securities or threshold list securities
Large failure to deliver positions in an account, often in multiple securities
Continuous failure to deliver positions
Using buy-writes, married puts, or both, particularly deep in-the-money buy-writes or married puts, to satisfy the closeout requirement
Using buy-writes with little to no open interest aside from that trader’s activity, resulting in all or nearly all of the call options being assigned
Trading in customizable FLEX options in hard-to-borrow securities or threshold list securities, particularly very short-term FLEX options
Purported market makers trading in hard-to-borrow or threshold list securities claiming the exception from the locate requirement of Regulation SHO; often these traders do not make markets in these securities, but instead make trades only to take advantage of the option mispricing
Multiple large trades with the same trader acting as a contra-party in several hard-to-borrow or threshold list securities; often traders assist each other to avoid having to deliver shares.