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.
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), legal insurer Pre-Paid Legal ( PPD), publishing company Martha Stewart Living Omnimedia ( MSO) and mortgage lender NovaStar Financial ( NFI). 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.
On Wall Street, the technical term for this is "failure to deliver" the shares. That's because every time a broker lends out shares to a short-seller, the broker also must be able to either borrow the shares from another firm, or produce the shares when the trade is supposed to settle three days later. Before Regulation SHO, failure-to-deliver scenarios were frequently one of the factors that led to the spread of naked shorting, either by design or neglect. But the new rule rectifies this situation by forcing brokers to close out trades where there are no shares available to settle a trade. Mary Ann C. Bartels, a Merrill Lynch trading strategist, agrees that the threshold lists could present some interesting opportunities for nimble traders. In a recent research notes, she says "threshold securities are likely to experience higher-than-usual price volatility due to a higher probability for a short squeeze." In addition, Bartels says some traders may become "more cautious" about trading until more is known about Regulation's SHO's impact on the market. Bartels' own list of potential threshold stocks includes online travel publisher Travelzoo ( TZOO), electronic toy manufacturer LeapFrog ( LF) and broadband company Charter Communications ( CHTR). The inclusion of a stock on a threshold list is no guarantee that the stage is set for a short squeeze rally. The hedge fund trader says an investor has to consider a variety of factors, such as the impact of earnings, the potential issuance of new shares by the company and the size of any gains posted by the stocks in 2004. He says many of the stocks likely to be classified as threshold securities are ones that "have had a good run already" and are poised for a selloff. Still, Regulation SHO and the threshold list give traders a whole lot more to think about before investing or shorting a small-cap stock.