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.

What Does Regulation SHO Cover?

Regulation SHO governs short selling of equity securities. Its key components are:

1. Order marking requirement
2. Locate requirement
3. Close-out requirements
4. Short sale price test circuit breaker (alternative uptick rule)

How Must a Sell Order Be Marked?

Every sell order must be marked as one of three designations:

A sell order may be marked "long" only if both conditions are met: ownership AND delivery capability.

What Is the Locate Requirement?

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.

When Does the Short Sale Price Test Circuit Breaker Trigger?

The alternative uptick rule under Reg SHO:

• 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% intraday while the restriction is already active, the circuit breaker is re-triggered: the restriction continues for the remainder of that day plus the next trading day
• The alternative uptick rule 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.
• A second 10% intraday decline while the restriction is already active re-triggers it, extending the restriction through the remainder of that day plus the next trading day.

What Are Common Short Sale Strategies?

What Is 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.

What Should You Check on Exam Day?

• Mark a sell order "long" only when the seller both owns the security and can deliver it by settlement.
• Confirm the locate happens before the short sale executes, with bona fide market makers as the only exemption.
• Trigger the alternative uptick rule at a 10% decline from the prior day's close, and remember shorts can then execute only above the national best bid.
• Treat short against the box as a constructive sale, not a tax-deferral strategy.