What Is Short Exempt? Definition and How It Works in Trading

What Is Short Exempt?

"Short exempt" refers to a short sale order that is exempt from the price test of the Securities and Exchange Commission’s (SEC) Regulation SHO. The current implementation of this regulation contains a modified version of the uptick rule, which restricts the price of short sale orders on a security whose price is falling.

The current regulation allows for a comparatively small number of restrictions, and within those restrictions are an even smaller fraction of exceptions to that rule. These exceptions are intended to allow brokers to best serve their customers in panicked markets.

Understanding Short Exempt

Standard market procedures require security sales to be labeled as "long," "short," or "short exempt." Short exempt orders are allowed even in circumstances where short selling may be otherwise restricted. These are statistically very rare and most retail traders would not experience the effects of these restrictions or their exemptions because the modified uptick rule only kicks in under extreme circumstances, and the exemptions are largely targeted at institutional traders.

The short exempt marking was added under the 2010 modifications. Thus, an order to buy is marked long and a short sale that complies with the modified uptick rule is marked short. A short sell order marked as short exempt is an order that is being transacted under one of the exemptions set out in Regulation SHO.

Short Selling

Short selling typically refers to an exchange of securities through a broker on margin. Broker-dealers loan securities to clients for the purpose of short selling. Broker-dealers can only execute short sales under certain conditions, as defined by regulation. Generally, the broker-dealer will transact these securities for the client for the purpose of short selling which requires the transaction to include short or short exempt markings.

Short selling in securities is intended to help participants profit during falling markets, and bring more participants into the markets at a time when investors may be retreating. To discourage any amplifying effects in a panicked market, the SEC implemented Regulation SHO in 2005 and modified rules regarding short-selling orders in 2010.

Regulation SHO

Regulation SHO is a regulation overseen by the SEC that is intended to prevent naked short selling and other abusive practices. It also included the original version of the uptick rule, in order to prevent short sales from contributing to downward volatility. These rules come into play during times when the market may be at risk of losing participants (liquidity) and it discourages those who would exploit such a market.

In 2010 the SEC modified Rules 200(g) and 201 of Regulation SHO to loosen the constraints on short selling. The new version of the rule, known as the circuit breaker, is only triggered when the price of a security drops by more than 10% in a single day and remains in effect until the next day's closing. When this condition is triggered, brokerages may only execute short sale orders at a price that is greater than the current national best bid, unless those sales are exempt.

When a Trade Can be Marked "Short Exempt"

Rule 201 lists a small number of circumstances where brokers can allow short sales that would otherwise violate the alternative uptick rule. Brokerages are allowed to execute and display these orders under the label "short exempt," provided that they adopt reasonable policies to prevent trades from being incorrectly labeled.

A trade may be labeled "short exempt" and executed at a price lower than the national best price if one of the following applies:

• The seller owns the shares being shorted but is restricted from delivering them at the time that the short-sale order is placed.
• The short-sale order is being made by a market maker in order to resolve an odd-lot position.
• The short-seller is attempting to arbitrage between price differences within the domestic or international market, with certain conditions.
• The short-sale is made in connection to a lay-off sale or over-allotment.
• It executed on a volume-weighted average price basis, with certain conditions.

Though the SEC oversees brokers who issue short-sale orders, they do not execute regularly scheduled audits. Instead, the SEC requires broker-dealers to self-regulate, by enforcing their own policies and maintaining records that are subject to audit at any time.

Broker-dealers mark an order short exempt if they believe in good faith that it qualifies for an exception. Marking for these orders is signified by SSE. All orders marked SSE will be closely checked by self-regulatory organizations and the SEC for compliance with Regulation SHO exceptions.

Correction–Jan. 9, 2022: A previous version of this article incorrectly stated some of the exemptions to regulation SHO.