Short Sale Requirements and Strategies
Short selling (selling borrowed shares in anticipation of a price decline) is heavily regulated under Regulation SHO. This is one of the most frequently tested areas in the Trading and Settlement section.
Regulation SHO Overview
Regulation SHO governs short selling of equity securities. Its key components are:
- Order marking (Rule 200)
- Locate requirement (Rule 203)
- Close-out requirements (Rule 204)
- Short sale price test circuit breaker (Rule 201)
Order Marking (Rule 200)
Every sell order must be marked as one of three designations:
| Marking | When Used |
|---|---|
| "Long" | Seller owns the security AND it is in the broker-dealer's possession/control or reasonably expected to be delivered by settlement |
| "Short" | Seller does not own the security or cannot deliver it by settlement |
| "Short exempt" | Specific exemptions under Rule 201(c) or (d) apply |
A sell order may be marked "long" only if both conditions are met: ownership AND delivery capability.
Locate Requirement (Rule 203)
Before effecting a short sale, a broker-dealer must do one of the following:
- Borrow the security, OR
- Enter into a bona fide arrangement to borrow, OR
- Have reasonable grounds to believe the security can be borrowed and delivered by settlement
Timing matters: The locate must be obtained before accepting the short sale order, not after.
Exception: Bona fide market makers are exempt from the locate requirement to facilitate customer orders in a fast-moving market.
Exam Tip: Gotchas
- The locate must happen BEFORE execution, not after. A firm that executes a short sale first and tries to locate shares later violates Regulation SHO.
- Bona fide market makers are the only exemption from the locate requirement.
Short Sale Price Test Circuit Breaker (Rule 201)
This is the alternative uptick rule:
- Trigger: A stock declines 10% or more from the prior day's closing price
- Restriction: Once triggered, short sales may only be executed at a price above the national best bid (uptick from the bid)
- Duration: The restriction remains in effect for the remainder of that trading day and the following trading day
- If the stock declines another 10% while the restriction is already active, the timer resets for the remainder of that day plus the next day
- Rule 201 applies only to NMS (National Market System) stocks. It does not cover options, futures, or warrants
Exam Tip: Gotchas
- The trigger is 10% from the PRIOR DAY'S close, not the current day's open.
- Once triggered, shorts can only execute ABOVE the national best bid (not at or below it).
- The restriction lasts the rest of that day AND the following trading day.
Short Sale Strategies
| Strategy | Purpose |
|---|---|
| Speculation | Profiting from an anticipated price decline |
| Hedging | Offsetting risk in a long position (e.g., short against the box) |
| Arbitrage | Exploiting price differences between related securities or markets |
Short Against the Box
- Selling short a security the investor already owns (long position)
- Locks in the current price without immediately triggering a taxable sale
- Tax note: Under current tax law, short-against-the-box transactions are generally treated as constructive sales, making this strategy less effective for tax deferral than it once was
Think of it this way: If you sell short a stock you already own, the IRS views it as if you sold your long position. You cannot use this technique to delay paying capital gains taxes.
Exam Tip: Gotchas
- Short against the box is treated as a constructive sale for tax purposes, so it no longer provides a tax deferral benefit.