The Securities and Exchange Commission today 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 appear to evade certain requirements of the short-sale rule.  The alert describes the strategies used by some customers, broker-dealers and clearing firms, summarizes related enforcement actions, and notes practices that some firms have found to be effective in detecting and preventing trading intended to evade the rule, known as Regulation SHO.

Regulation SHO tightened requirements for short sales, which involve sales of borrowed securities. Short sellers profit from price declines by replacing borrowed securities at a lower price.  Under Regulation SHO, short sellers who fail to deliver securities after the settlement date are required to close out their position immediately, unless they qualify as bona fide market makers for a limited amount of extra time to close-out.  As noted in the alert, the trading strategies observed by the OCIE staff may give the impression of satisfying the Regulation SHO “close-out requirement,” while in effect evading it.  These sham close-outs violate the SEC rule, which aims to ensure that trades settle promptly, thereby reducing settlement failures.

“This Risk Alert encourages awareness of options trading activity used to avoid complying with the close-out requirements under Regulation SHO,” said OCIE Director Andrew Bowden.  “The alert describes these trading activities in detail to help broker-dealers and their correspondent clearing firms avoid the regulatory and reputational risks that are posed by these activities.”

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 close-out 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

Eric Peterson and Tom Mester of the National Exam Program staff contributed substantially to the preparation of this Risk Alert.  They received valuable input from the Division of Trading and Markets and the Division of Economic and Risk Analysis.