Going Long the Short List

The new rule, which some short-sellers have criticized, is supposed to bring the market back into balance. Over the next few weeks, the New York Stock Exchange, the Nasdaq Stock Market and other exchanges will compile so-called "threshold lists" of hard-to-borrow stocks that are more likely to be involved in naked-shorting transactions. The lists, which will be updated daily, are intended to serve as red flags for brokers and traders.

The expectation is that most of the equities on the lists will be small-cap stocks with high short-interest ratios and low floats. Traders looking to place new short bets against these stocks likely will find themselves turned away by their brokers, or forced to pay a premium price when shares are available to borrow.

To give Wall Street an idea of the kind of stock likely to be red-flagged, the NYSE published a preliminary list of 104 threshold stocks. The list is dotted with some familiar short-seller targets: doughnut chain Krispy Kreme(KKD Quote), legal insurer Pre-Paid Legal(PPD Quote), publishing company Martha Stewart Living Omnimedia(MSO Quote) and mortgage lender NovaStar Financial(NFI Quote).

But some hedge funds, shut out of the possibility of further shorting a stock, are planning to use the threshold lists to profit on the long side. A trader with a Midwestern hedge fund says he's eyeing the list with the idea of putting together a basket of stocks that might be ripe for a short squeeze. (The trader spoke only on condition of anonymity.)

A short squeeze is a situation in which traders must scramble to close out short positions by buying shares. A short squeeze often accelerates the rise in a stock because the furious buying by panicky shorts only pushes the price of the stock higher.

Some savvy traders say the new rule may lead to occasional short-squeeze scenarios, especially if brokers are forced to close out short positions opened by their customers because the shares weren't available to lend out in the first place.