Obscured Tatics Used in Naked Short Selling
Some options traders are skirting short-selling rules using a complex trade that has caught the attention of regulators.
The Securities and Exchange Commission has rules that limit the use of short selling, by which traders sell stock they don't own. But Dow Jones Newswires has found cases of market makers skirting those rules with a trade involving stocks and options. It enables them to refresh short positions without having to deliver the stock within six days, as the SEC demands.
The practice isn't common, and the opaque nature of the options market means it is impossible to identify which market makers are doing this. Nevertheless, the Financial Industry Regulatory Authority told Dow Jones Newswires it has an "active docket" of such cases it is examining.
The trade works like this: A market maker who needs to cover a short position buys the stock from person A and delivers it to person B. The market maker then sells "calls" to person A -- options that convey the right to buy a similar amount of stock. Since the market maker is selling the options, he is now in a position to sell the stock. After a day or two, person A exercises the options, obliging the market maker to deliver the shares, leaving him with his original short position.
Since August, Dow Jones has reviewed more than half a dozen cases where this trade appears to have occurred, involving the stock of companies such as Sears Holdings Corp. and American Capital Ltd.
The Financial Industry Regulatory Authority also is reviewing such cases. "These would be sham transactions used to make sure that the market maker maintained its hedging short-stock position," said Tom Gira, executive vice president for market regulation at Finra.
Market makers routinely sell stock short to hedge positions they take in options, thereby greasing the wheels of the options market. If they sell a put or buy a call, they sell stock to cushion themselves against falling share prices that hurt the value of their options.
Right now, an options market maker who has sold a stock short has six days to deliver shares to the buyer. They usually borrow the shares from an institution with a large inventory of the stock, such as a pension fund or bank.
Sometimes, however, market makers struggle to borrow the shares or find it is too costly to do so. Other times, the lender wants the stock back.
If they fail to deliver the stock within six days, they could be forced to buy it back and potentially lose millions of dollars, said OptionMonster co-founder Jon Najarian.
The trade under review allows them to avoid this scenario because it restarts the clock on the six-day deadline.
The trade could also be used as part of an arbitrage, where market makers profit from an imbalance between the prices of puts and calls.
When a company's stock is hard to borrow, sometimes its puts are more expensive than its calls. Market makers can profit from the situation by selling the puts and buying the calls.
This is known as a reverse conversion, effectively giving the market maker a long position in the stock. To avoid losing money if the company's stock drops, market makers short it as a hedge.
In July 2007, two market makers who are brothers, Scott Arenstein and Brian Arenstein, paid fines of $3.6 million and $1.2 million, respectively, after the American Stock Exchange pursued disciplinary action for conducting similar trades. In paying the fines, the Arensteins neither admitted nor denied the charges.
"With the Arenstein case, we felt like we had cracked the code, so to speak," Finra's Mr. Gira said. "Now, we're looking for similar activity."
Sorce: Dow Jones newswires
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