Why The Shorts Have Long Faces

Traders are taking advantage of a new SEC rule to bid up shares of shorted stocks

For investors in Martha Stewart Living OmnimediaInc. (MSO ), the past two months have been "a good thing," as the domestic diva likes to say. Since early December, the company's shares have shot up over 50% in value. News that Martha will host a new reality-TV show after her release from prison in March helped.

But some market mavens point to another reason: a maneuver by savvy traders to squeeze short-sellers, who borrow stock and sell it in the hope of buying it back for less later because they think the stock is overpriced. Traders put on the squeeze by buying large amounts of Martha Stewart stock to drive up its price and force the shorts to cover their positions at a loss. "Martha has really ripped," notes Stephen Monticelli, president of San Francisco hedge fund Mosaic Investments LLC, who says he locked in a 10% gain in four days.

Monticelli and others are exploiting a new Securities & Exchange Commission regulation designed to crack down on abusive short-selling. Since early January major stock exchanges have had to publish daily lists of companies for which sellers have failed to deliver sizable amounts of stock to buyers in a timely fashion. That situation often arises when traders engage in what's known in the market as "naked shorting." Normally short-sellers have to borrow stock before they sell it. But sometimes brokers execute a short sale without having a firm arrangement to borrow shares -- and then find they can't locate the necessary stock. The new regulation is prompting brokers who can't deliver stock within 13 trading days to close out customers' short positions.

The daily lists signal to other traders that they can pluck profits by mounting a short squeeze in stocks, such as Martha Stewart Living Omnimedia, that are already moving up on positive news. For example, ParkerVision Inc. (PRKR ), a Jacksonville (Fla.) maker of wireless devices, has seen its shares soar 62% since it appeared on the list in early January. (A ParkerVision spokesman attributes the rise to the Jan. 20 announcement of a potentially breakthrough product.) "If you have a small-cap stock with a huge short position on a list, you just raised a flag for potential manipulation," says Jeffrey Meyerson, a vice-president at Crown Financial Group, a Jersey City (N.J.) brokerage firm.


Executives of companies who feel their stocks have been penalized by naked shorting are delighted. "This is absolutely a step in the right direction," says Patrick Byrne, chief executive of Overstock.com Inc. (OSTK ), a Salt Lake City-based discount e-tailer.

But critics who believe that the shorts play a critical function in the markets are angry. They contend that the new SEC regs will increase market volatility and manipulation, particularly among smaller stocks. "The SEC bungled it," says James J. Angel, an associate professor of finance at Georgetown University. "By making it harder to short-sell, it's going to become easier for the pump-and-dump artists to pump shares and then sell them at high prices to unwary investors." Says an SEC official: "It's not something we're seeing."

Some short-sellers contend that brokerage firms are already trying to profiteer from the new rules by slapping extra fees on hard-to-borrow stocks. At Harrisdirect, a division of Chicago-based Harris Bank LLC, investors who want to short Internet travel-offer publisher Travelzoo Inc. (TZOO ) must pay an extra fee of $31.40 a month per 100 shares they want to short. For Cal-Maine Foods Inc. (CALM ), an egg producer that rode the Atkins Diet craze to new heights, the cost of shorting has risen to $3 a month per 100 shares on the $10 stock. Harrisdirect's chief operating officer, Michael Hogan, says the company is simply passing along the fees it's now being charged by large Wall Street firms.

Harrisdirect officials acknowledge that the fees are putting a damper on short-selling activity. "It has had an impact," says Hogan. "In some of these stocks the economics becomes uninteresting." While that could be a short-term gain for bulls, for the longer term, it could turn out to be a loss for the markets.

By Dean Foust in Atlanta

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