Going Long the Short List

Life has just gotten a bit more difficult for short-sellers.

A new securities regulation, which went into effect Monday, is expected to make it harder and more expensive for traders to bet against many stocks that are favorites of bears.

Ironically, some predict the new rule could even lead to periodic rallies in some of these heavily shorted names, as traders are forced to buy shares to close out their short positions.

Regulation SHO, as the measure is known, is part of an effort by the Securities and Exchange Commission to crack down on abusive short-selling practices. Wall Street brokerages are scrambling to comply with the new rule, which could have big ramifications for hedge funds and other traders that like to short tiny stocks with few shares available for trading.

The rule doesn't alter the basics of short-selling, a time-honored way for traders to make money by borrowing shares from a broker and betting a stock will decline in price. Short-sellers hope to profit by selling borrowed shares and later replacing them with cheaper ones.

But the new rule does clamp down on naked shorting, an unsavory practice in which traders place short bets without actually borrowing shares -- or even determining that any exist to borrow.

The rule prohibits brokers from permitting traders to short a stock unless there are "reasonable grounds" for believing there are shares available to borrow. If those shares cannot be later found, the rule sets down a procedure for brokers to close out the short positions in relatively short order.

Regulators contend that unchecked naked shorting has led to an anomalous situation in which the total number of shares sold short on a stock can exceed its float -- the total number of shares available for trading. In essence, short-sellers are able to "print" shares of stock when none were otherwise available.