August 16, 2007
I'm sure that you are already aware of how the Options Market Makers are used by short selling hedge funds to skirt the SHO rules.
However, for the sake of other readers let me review a trade which I have seen take place over and over again for stocks which are already on the Reg SHO list of restricted shorts.
The trade looks like this. A large number of deep in the money PUTs is traded simultaneously with a huge number of common shares. By large I mean in the range of 5,000 to 10,000 PUT contracts along with 500,000 to 1,000,000 shares of stock. Following that trade the stock is then immediately pressured as the shares of stock are sold into the market in an attempt to drive down the stock price. The seller of the common is protected from losses on the common stock by the gains of the deep in the money PUTS he holds, which offset nearly penny for penny, his losses from the sale of the stock price. Following this trade the volume of stock being traded dramatically increases and the stock price declines a lot.
The buyer of the PUTs and the buyer of the Common is almost certainly one in the same because the option and common trades take are matched in quantity and they place within seconds of each other.
What I believe is going on here is this. First off, it is important to understand that the hedge fund or institution is using this strategy to work down the price of a stock in which he currently holds a large short position. That hedge fund or institution offeres to buy deep in the money PUTs and Stock from the Option Specialist. Even though the stock is hard to borrow or on the reg SHO restricted list, the Option Specialist can take this trade because reg SHO currently allows him to sell naked shares shares in order to make a market. So, even though a stock is on the restricted SHO list, as a result of this loophole in reg SHO, any hedge fund can always create a large short term short position by simply working with his friendly option specialist.
As I said earlier, since this happens so frequently, I am sure that the SEC is already aware that this goes on. To stop this, reg SHO must be changed so that the option specialists and stock MM can not sell shares short for any stocks which are on the reg SHO restricted list.
I would also add, that manipulating stocks has been illegal since 1934. So, in addition to making changes to reg SHO, I suggest that the SEC simply look into some of the trading patterns for stocks such as NFI, OSTK and MSO. There you will find numerous examples of the trade which I just outlined. And, I suspect that you will find that it is the same hedge funds and option specialists who engage in this practice over and over. Since the sequence of events and the result is always the same, it should not be hard to prove that the intention of this trading is to manipulate the price of the stock.