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.

Tactic Lets Traders Dodge Rule on Short Selling - wsj.com

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