The SEC named optionsXpress, its former CFO, and a customer of conducting an abusive naked short selling scheme.  The SEC Order against the 3 respondents provides a road map to the scheme - detailing securities trade, related securities activities and transactions, and rules that were violated in the process. To read further about the Commission's case against the 3, go to:  [Abusive Short Selling Charges - Firm, Its ex-CFO, and a Customer, WWW, 4/17/12]. The Violative Trading. Six customer accounts at optionsXpress engaged in reverse conversions and similar options trading strategies starting on or before October 2008.  To execute these strategies:

• Customers simultaneously sold a put and bought a call with identical strike prices and expiration dates - this created a synthetic long position.
• Customers also would create a short position to hedge their synthetic long position - generally by selling deep-in-the-money calls.
• The synthetic long position and the short position were for an equal number of shares/contracts.
• Through this set of transactions, the Customers eliminated directional risk in the stock price.

(Note: A "deep in-the-money" option has a strike price that's far below (in the case of a call option) or far above (in the case of a put) the market price for the given security.)

• Deep-in-the-money calls sold to create the short position referenced hard-to-borrow securities and were frequently exercised.
• After the options were exercised and assigned to the Customers, the Customers had a synthetic long position and a short stock position for which they (and optionsXpress) were required to deliver shares by T+3.
• However, neither optionsXpress nor the Customers delivered the shares by T+3, thus creating a failure-to-deliver position.
• Instead of delivering the shares, optionsXpress and Customers would give the appearance of closing out their fails by entering into a "buy-write" - i.e., they would simultaneously buy the shares they needed to cover the failure-to-deliver position and write (sell) deep-in-the-money calls representing an equivalent number of shares.
• optionsXpress, CFO Thomas Stern, and Customers knew, or were reckless in not knowing, that most, if not all, the calls that were sold as part of the buy-writes would be exercised and assigned on the same day they were sold, resulting in shares not being delivered on settlement.
• Thus, optionsXpress, Stern, and Customers knew, or were reckless in not knowing, that these transactions would result in failures-to-deliver.

(Note: Selling deep-in-the-money calls is essentially the economic equivalent of selling shares unless the stock price drops precipitously and therefore approaches the strike price.)

• To enter into the buy-write, Customers paid a certain amount, generally between 1 and 2 pennies per share.
• The newly written deep-in-the-money calls were generally exercised the same day they were sold (and thus were assigned to Customers later the same day) putting Customers back in their original short position, continuing the fails, and causing them to enter into another buy-write the following day.
• As a result, optionsXpress maintained a net short position at the end of each day.
• The buy-writes continued on a daily basis until the original synthetic long position was unwound or expired.  As a result, optionsXpress had a negative position in the NSCC continuous net settlement ("CNS") system for extended periods of time.
• While the daily use of buy-writes gave the impression that optionsXpress was closing out the failures to deliver as required, optionsXpress and Customers were simply kiting stock to maintain the naked short position.
• Put another way, the buy-write was a matched order entered for the improper purpose of appearing to close out delivery fails without actually delivering the shares.

• Customers profited from the transactions because they: (i) sold the initial position "for a credit"; (ii) took no risk with respect to the change in the price of the stock and options that occurred over the life of the position; and (iii) did not incur the costs associated with borrowing or purchasing sufficient shares to make delivery on the short sale.
• Customers received a net credit for their initial position because of a difference in the relative value of the put and the call.  Normally, the price of the put and the call will be in parity; however, the stock associated with the options traded by Customers was generally hard-to-borrow and therefore expensive to borrow.  As a result, cost of borrowing the stock was incorporated into the price of the put  - which made the value of the put higher relative to value of the call.
• Due to cost of borrowing such hard-to-borrow stocks, the increased price Customers received for selling the put would have been completely offset by the cost of instituting and maintaining the stock position, had optionsXpress and the Customers complied with their delivery obligations.  In order to comply with those obligations, they would have had to borrow or purchase shares of the underlying stock in order to close-out the failure-to-deliver position.
• optionsXpress profited from the commissions it received on the transactions.

• By engaging in the buy-writes and thus having a constant unsettled stock position, optionsXpress, and the Customers were able to evade the requirements of Reg. SHO at a relatively minimal cost, thereby maintaining the profitability of the trade.
• By not delivering shares, optionsXpress and its Customers were extracting a profit at the expense of the true purchasers of the shares.  There was no legitimate economic purpose to the buy-write transactions.
• Indeed, the buy-writes standing alone were economically nonsensical because they cost the Customers money.  Their purpose was to perpetuate a failure to deliver.  This is not a legitimate economic purpose.

• optionsXpress’ website notes that under normal circumstances the chance to execute profitable reverse conversions is extremely limited: "Individual investors and most other off-the-floor traders don’t have an opportunity to do conversions and reversals because price discrepancies typically only exist for a matter of moments.
• Professional option traders, on the other hand, are constantly on the lookout for these opportunities.  As a result, the market quickly returns to equilibrium."
• Customer trading strategies - securities and time period for the overall period - 10/7/08 to 3/18/10 - are available in the SEC Order - link provided above.

• As a result of the trading, optionsXpress had a continuous failure-to-deliver position in these securities for extended periods of time.
  • e.g. - optionsXpress had a failure-to-deliver position in Sears for at least 236 continuous settlement days during 2009-2010.  In total, during the relevant period, optionsXpress had failures to deliver in at least 25 issuers at least 1,317 times.
• During this period, NSCC sent optionsXpress numerous notices of intention to buy-in for many of the securities listed in the SEC Order.  Such notices are sent to those clearing brokers with the oldest failure-to-deliver positions when requested to do so by clearing brokers with failures to receive.

• The daily volume of Customers’ trades in some of these issuers the SEC noted was a significant portion of the securities’ total daily trading volume.
  • e.g. - 1/1/10 and 1/31/10, the Customers traded between 832,000 shares and 1,603,000 shares of Sears Holding Corporation stock a day which accounted for between 15.6% and 62.2% of Sears’ daily trading volume.  On average in the month of January 2010, Customers accounted for 48% of the daily trading volume in Sears.
• In 2009, Customers combined purchased a total of approximately $5.7 billion worth of securities and sold short a total of approximately $4 billion of options through their accounts at optionsXpress.
• In 2009, Feldman purchased at least $2.9 billion of securities and sold short at least $1.7 billion of options through his account at optionsXpress.

For further details, go to:   [SEC Order against optionsXpress, Stern, Feldman].