In September 2008, the Securities and Exchange Commission (SEC) instituted emergency rules to penalize short sellers who failed to deliver borrowed shares at settlement (naked short selling). These rules were set to expire on July 31, 2009, but on July 27, the SEC made them permanent. Why is this important?
Short selling a stock is essentially betting against a stock. Short-sellers borrow shares of a stock, sell them and then hope to buy them back at a lower price when it is time to return them to the lender. The difference in price is the short-sellers profit – or loss, if he bets wrong.
Short selling, while not considered an abusive tactic, can cause sudden plunges in a stock’s price. The SEC used to have strict rules regulating short sales to prevent abuse. One of the most important of these was the uptick rule. This rule allowed short sales only when the market was advancing. Completion of a short sale required that the previous trade be an uptick in price of at least one penny. If a stock’s price was already falling, and the last trade was a downtick, a short sale was not allowed. This rule, passed in 1938 in response to the Great Depression, was repealed in July 2007.
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Unlike regular short selling, naked short selling is an abusive practice. Naked short selling involves the sale of a stock that the seller does not own, has not borrowed, and is not sure he can obtain. This practice is not only abusive but is potentially destabilizing to the market. It is this abusive practice that the new permanent rule (Rule 204) prohibits.
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Rule 204 requires brokers acting on behalf of short sellers to buy or borrow shares within three days after a short-sale trade. Failure to deliver the shares within that time may result in penalties for the broker if the failure is not resolved by the start of trading the next day. This restriction effectively bans naked short selling.
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In addition to the ban on naked short selling, the SEC is considering implementing new rules on regular short selling, including reinstating the uptick rule. The goal is to prevent the rapid plunge in a stock’s value that can occur when there is a rush of short selling that feeds on itself. Selling sprees are believed to have contributed to the dramatic stock market declines seen over the past year.
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The SEC also would like comprehensive data on short selling to be available on the websites of the major stock exchanges. Officials believe this will result in greater transparency and reduction in abusive practices. Previous trends toward less regulation of financial markets have been disastrous, to say the least.
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While investors may find it more difficult to short a stock trade, other options are available, investing with stock options for example. Investors not able to short a stock trade can use put options to take a bearish position for a stock. If the price of the stock significantly declines, the put option will pay off handsomely.
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Option investors can also take a bearish position on a stock with bear call credit spreads. A bear call credit spreads consists of a short call option and purchasing a higher strike call option for a net credit. As long as the price of the underlying stock is below the strike price of short call option, the position remains fully profitable, with the investor keeping the initial net credit as profit.
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[tags] Securities and Exchange Commission, SEC, Short selling, uptick, Great Depression, naked short, Rule 204, brokers, short-sale [/tags]