High Probability ETF Trading, Short Selling and SEC Rule 204
For the past three weeks the U.S. stock market has been on a one-way move. Historically, in early stages of bull markets, this is very typical. For pullback traders it can be a bit frustrating as cash levels tend to be high as the market moves higher most days. Eventually though pullbacks will occur and historically the early pullbacks tend to do well as they are an opportunity for many money managers who missed the move to put cash to work.
This last run-up has been fueled by the fact that less stocks and ETFs have been available to be borrowed along with the fact that many, many funds and traders were forced by the brokerage firms to buy back into their short positions. The brokerage firms are now fully complying with SEC Rule 204 on short selling.
SEC Takes Further Steps To Curtail “Naked” Short Selling; Short Sale Reporting Rule To Expire
Investment Management Alert
by Kay A. Gordon, Mark D. Perlow, Richard Guidice, Jr . July 30, 2009
On July 27, 2009, the U.S. Securities and Exchange Commission (the “SEC”) announced several steps designed to curtail short sale practices that it described as abusive and to increase market transparency. First, the SEC made permanent, with minor modifications, an interim final temporary rule (Rule 204T) that generally requires broker-dealers to promptly purchase or borrow securities to deliver on a short sale (the “Interim Rule”). Second, the SEC announced that it would let expire temporary Rule 10a-3T, which requires institutional investment managers to make weekly filings describing their short sales and short positions; instead, the SEC will try to improve market transparency by working with its staff and several self-regulatory organizations (“SROs”) to make short sale volume and transaction data available via the SROs’ websites. Third, the SEC announced its intention to host a public roundtable on September 30, 2009 to discuss a number of related topics, including securities lending, pre-borrowing and possible additional short sale disclosures. Finally, the SEC stated that it is continuing to actively consider its recent proposals regarding short sale price tests (the “uptick rule”) and circuit breaker restrictions.
Adoption of Rule 204
New Rule 204 of Regulation SHO is substantially similar to the Interim Rule, with certain limited modifications: both require clearing firms to purchase or borrow securities to close out a “fail to deliver” resulting from a short sale in any equity security by no later than the beginning of trading on the day after the fail first occurs (T+4) (with certain exceptions for market making activities, which provide for T+6 close-out). The Interim Rule, which was originally introduced in response to concerns regarding “fails to deliver” and potentially abusive “naked” short selling, was approved by the SEC in the fall of 2008 and was set to expire on July 31, 2009. In adopting Rule 204, the SEC cited data from its own Office of Economic Analysis that shows that the number of “fails to deliver” dropped after the SEC adopted the Interim Rule. The key enforcement mechanism of the Interim Rule remains intact: if a clearing firm or broker-dealer has a “fail to deliver” position in a particular security, it must pre-borrow the securities needed to sell that security short until the “fail to deliver” position is closed out and the purchase is cleared and settled. The differences between new Rule 204 and the Interim Rule include the following:
Unlike the Interim Rule, Rule 204 provides that participants of registered clearing agencies as well as market makers may close out a “fail to deliver” position by borrowing, in addition to purchasing, securities, and that “fails to deliver” from long sales may be closed out by purchasing or borrowing securities. In addition, broker-dealers may close out these positions by purchasing or borrowing securities sufficient to cover the entire amount of the failure to deliver position; the Interim Rule required that the broker-dealer close out its entire open short position.
Rule 204(f) contains a new provision intended to address “sham” close-outs, specifying that a broker-dealer will not be deemed to have closed out a position if it enters into an arrangement with another person to purchase or borrow securities and either knows or has reason to know that the other person will not deliver the securities.
Rule 204 provides an exception from the close-out requirements to a greater universe of securities than does the Interim Rule: it exempts “fails to deliver” resulting from the sale of an equity security that a person is “deemed to own” pursuant to Rule 200 of Regulation SHO and that such person intends to deliver as soon as all restrictions on delivery have been removed. Rule 200 defines such securities to include securities that are restricted under Rule 144 under the Securities Act of 1933, as well as securities to be received after exercising an option, warrant or right or converting or exchanging another security, which includes securities to be received in a broker-assisted cashless exercise of a compensatory stock option; the Interim Rule only exempted Rule 144 securities.
Rule 204 revises the close-out period within which a participant must close out “fails to deliver” resulting from sales of such “deemed to own” securities to be consistent with the delivery period contained in Rule 203(b)(2)(ii) of Regulation SHO: the position must be closed by no later than the beginning of regular trading hours on the thirty-fifth consecutive calendar day following the trade date for the transaction; under the Interim Rule, the time frame was the thirty-sixth consecutive settlement day.
Rule 204 is effective as of July 31, 2009.
What this means is that you want to make sure you’re able to borrow stocks and ETFs ahead of time. And even then there’s no guarantee they’ll be there every day you’re in a position. For ETF traders, the safer route is to use the inverse funds. For example, if you’re going to go short the SPY, you would instead go long its inverse which is SH. This way you don’t need to worry about being bought in.
In my opinion, part of the rally the market has seen is tied into the enforcement of this rule. Short covering rallies are part of the market and in this case, this rally was likely exacerbated by forced buy-ins.
Before you short an ETF, look at its inverse on the long side. It’s a smarter move.
Special Note – I’ll be holding a 2 1/2 seminar on High Probability ETF Trading beginning this Friday night and running through Sunday. The ETF seminar will be the most comprehensive I’ve conducted including new research to day trade ETFs along with trading leveraged ETFs.
If you’d like to learn about the High Probability ETF Trading Seminar to improve your ETF trading you can attend a free presentation this Tuesday and Thursday. Click here for details.
Larry Connors is CEO and Founder of TradingMarkets.com and Connors Research.