How does "naked" short selling work?

Question

I understand the basics of short selling: an investor makes money off of betting the share price will go down. But can someone give me more details on short selling? Is it legal? Why does it have such a bad reputation? And what is "naked" short selling?

Answer 1

Most everyone has the short part right, but not the 'naked' part.

1st of all, they are both legal. That is why it is so frequently done. The terms are 'naked' & 'covered' that you are looking for. Most short sellers are 'naked'. It is much less comon to be a covered shorter than naked. The term refers to whether or not you own the same possition you are short in.

Ex: you own 100 shares of XYZ Inc. You still wish to own it but you think you can make a few bucks on a play b/c you think that a trend down will happen. You short 100 shares of XYZ, or borrow 100 shares to sell to someone else at $20/share. The price goes down to $14/share & you buy it back & deliver it back to who you borrowed it from & pocket $600 ($2000 borrow price - $1400 buy back price) for your troubles less any fees. The only difference with this transaction that makes it covered or naked is the fact that you already owned it before the short. Here is why it is important:

This same transaction would transpire this way if it goes against you: You short 100 shares that you own & the price goes up. It goes to $29/share. If you chose to get out of that possition (remember, you can hold it if you still think it will go down again), you can transfer you shares that you already own for zero cost other than what you have already paid for it. That way, you do not have to pay $2900 for the short that when wrong.

That is a 'covered' short b/c your short possition is 'covered' with stock that already have. If you were 'naked' aka 'uncovered', you would be on the hook for the $2900 b/c you could not 'cover' it any other way. It is the same with covered & naked calls & puts.

Hope this helps. I know you are looking at conflicting info, but I am Series 7 certified & you can look it up or call your broker to confirm.

Answer 2

Short selling is the practice of borrowing stock, then selling it in hopes that the price will go down and it can be bought back at a lower price, generating profit and allowing one to return like shares for the borrowed ones.

"Naked shorting" refers to "shorting" a stock for sale without first borrowing it.[1] When one sells short a non-borrowed stock, one is selling something that one does not possess. The risk that one may not be able to then acquire the shares needed to deliver on the sale is a contributing factor to the controversy surrounding this practice.

Short selling is legal.

It gets much criticism because it makes you face infinite risk. Normally when you invest, the most you can lose is the value of your investment. In short-selling, it can be a lot more. i.e. if you short a stock at $1 and it goes up in value to $5, you owe the full $5.

It also gets ridiculed because people do not like the idea of being able to bet against the government. however, other might argue that it is a necessary market force which keeps prices efficient.

Answer 3

Basically, being "naked" anything means you have never owned it. Short selling means you do not own the particular stock you are shorting. However, naked shorting means the stock is not available to be borrowed.

Here's how it works: Either you do research on a company, a company reports less than stellar earnings, or you receive a tip. It is found that the company's stock will decrease in value. You go to your brokerage account and tell them you want to short stock XYZ. A certain amount of existing stock in that brokerage account will be sold at market value. The stock sold belongs to someone else...could be Joe Shmoe next door. Your responsibility is to eventually buy it back at some point to replenish the volume held by the firm - and more directly, replenish Joe Shmoe's stock. "Naked" would mean the brokerage firm can't find the stock but allows you to short it anyway.

Normal shorting is not illegal but before you do it, you will need a certain margin account balance with the firm to short sell - or speculate in any way. Shorting is one of the ways hedge funds work.

HOWEVER, naked short selling is illegal since the stock is not available at all and the brokerage firm still allows you to short sell.

-Ron Rock, ChFC

Answer 4

Two sort of correct answers above. Let's see if I can straighten this out:

Short selling is, indeed, selling a stock which you have borrowed. The seller pays a carrying cost to the owner of the stock, and will eventually need to return it. He is betting that the stock goes down: if it does, he buys it back at a lower price than he sold it for and returns it. If the stock goes up, he covers above the sale price and loses money.

When stocks go up quickly, short sellers are forced to cover their bets. This is called a "short squeeze", because as the short sellers create sudden demand for the stock the price skyrockets.

Short sellers are hated by stockholders, because they are believed add negative pressure to stock prices. In fact, short selling borrowed stock is neutral to stock price (because every sale is also a buy). This form of short selling is perfectly legal.

Naked short selling is an illegal activity, basically a form of counterfeiting. When a stock is shorted, the seller must perform a borrow and deliver good stock to the buyer. But because of inefficiencies in our settlement system, a clever operator can sell stock without delivering. This results in a "fail to deliver", or FTD. An FTD functions like an IOU, and looks like real stock to the buyer. FTD's are technically required to be covered within ten days, but loopholes in the law sometimes allow them to remain indefinitely. They circulate through the system just like real stock.

Why does someone do this? It's not to avoid the carrying fees. If you don't have do a stock borrow, you can continue to sell stock indefinitely. Every sale drives down the price a bit, because it inflates the float with false promises to deliver. Predatory investors can use this technique to drive a company's price down in order to achieve a takeover goal. In the past, naked shorting has been associated with so called "death spiral financing", where a lender is repaid in company stock. By naked shorting, the lender can force down the price of the company, which means the company has to use greater amounts of stock to pay the lender. In time, the lender owns the company. By that time, it's worthless, so the lender can liquidate the company and never have to make good on the naked shorts.

How can this be done? Naked short sellers are usually broker dealers, licensed to trade stock in the US. But they are often offshore entities, operating out of flag of convenience countries. This puts them below the regulatory radar. This is why, despite increased enforcement, there is still a long list of stocks on the "SHO" list: http://www.nasdaqtrader.com/aspx/regsho.aspx

I don't usually do this, but "Ricks" (below) is confusing a naked short with a short that's not "against the box". A short against the box is a legitimate short, where you borrow the stock from your own account. A reason you might do this is to hedge a specific, time-bounded risk, for example if you expect that an upcoming earnings report may be unfavorable. It's the equivalent of selling a covered call, with the strike at the current price, and the expiration date open.

Answer 5

If you are at the Craps table & bet against the dice (Don't Pass) you will be unpopular as you are going agianst the rest. Same with shorting. Not a bad rep but an adversarial situation.

Answer 6

as long as you make money, its ok