The Truth About Naked Short Selling

The basic form of short selling is selling stock that you borrow from an owner and do not own yourself. In essence, you deliver borrowed shares. Another form is to sell stock that you do not own and are not borrowing from someone. Here you owe the shorted shares to the buyer but “fail to deliver.” This form is called naked short selling.

Naked shorting is the illegal practice of short selling shares that have not been affirmatively determined to exist. Ordinarily, traders must borrow a stock, or determine that it can be borrowed before they sell it short. Due to various loopholes in the rules, and discrepancies between paper and electronic trading systems, naked shorting continues to happen.

These short sales are almost always done only by options market makers because they allegedly need to do so in order to maintain liquidity in the options markets. However, these options market makers are often brokers or large hedge funds who abuse the options market maker exemption.

Shorting Without Failing to Deliver

There is another form of short selling, sometimes called a synthetic short. This involves selling call options and/or buying puts. Selling calls makes you have negative deltas (a negative stock equivalent position) and so does buying puts. Neither of these positions requires borrowing stock or “failing to deliver” stock.

A collar is nothing more than a simultaneous sale of an out-of-the-money (OTM) call and the purchase of an OTM put with the same expiration date. Another way to short sell is to sell a single stock future, which is equivalent to naked short selling. No shares are borrowed, however, and no shares are failed to deliver.

Prepaid forwards and swaps are sometimes used to carry out short sales. However, these are done directly between the customer and some bank or insurance company, many of which have become suspect in terms of their ability to guarantee the other side.

Holding any one of the above positions alone or in combination with another essentially gives you a negative delta position whereby you will profit if the stock goes down.

Margin Requirements and Money Transfers

The following is exactly what happens when you do a short sale as mentioned above. You decide to sell some shares that you do not have because you may wish to reduce the risk of other long positions that you may hold or you wish to make naked bets that the stock will go down.

For example, you borrow shares that you wish to sell short and you instruct your broker to sell 1,000 shares at $50. Upon the sale, the $50,000 is credited to your broker’s account (not your account as some may think. This distinction is important). Then you must advance the required initial margin into your account to guarantee to the broker that there is money in your account to cover any loss you may incur if you lose on the short sale. The short seller must maintain the minimum maintenance requirement in his margin account. Of course, if the short seller is the broker, then both the broker’s account and the short seller’s account are essentially the same.

The broker earns interest on the lending of the proceeds of the short sale to other margin customers. That lender becomes the short seller when the broker is the short seller. When the broker acting as an options market maker does a naked short sale, he need not borrow shares and instead collects all of the interest on the proceeds for himself.

If the stock goes down after the sale of the 1,000 shares at $50—say to $45—then $5,000 is moved from the broker’s account to the short seller’s account, which can be removed by the short seller. His margin requirement goes down by 50% of the $5,000. On the other hand, if the stock goes up to $55, then $5,000 is moved from the short seller’s margin account to the broker’s account and the short seller’s minimum maintenance requirement will increase.

These money transfers take place exactly the same way whether you do a regular short sale or a naked short sale. There are similar future transfers if you have sold calls or sold single stock futures. When you buy puts and fully pay for them, there are none of these money transfers after the purchase, although the value of your account certainly fluctuates as the value of the puts fluctuates.

All of the above ways to obtain negative deltas cause pressure on the value of the stock similar to how straight sales of long stock put pressure on the price of the stock. In addition, these short-selling methods are sometimes used by those who have inside information about some negative future event to illegally profit by selling or shorting stock prior to the announcement of that future event. Combinations of the above positions with long positions, where summed net short equivalent stock positions are created, are often used to disguise illegal insider trades.

Media Pundits

Naked short selling is often in the news today and is criticized by journalists and other pundits who claim that naked short sellers allied with “rumor mongers” caused the collapse of Bear Stearns and Lehman Brothers. They cite the large “failure to deliver” for a stock as evidence of naked short sales days after the stock had dropped. Although the naked short sales happened after the collapse, they still hold onto the idea that those after-the-event naked short sales caused the collapse.

The large volumes of “fail to deliver” stock and the naked short sales after the collapses of Bear Stearns and Lehman Brothers leads me to believe there is an explanation for those large volumes. However, that strategy did not cause the collapse of those companies.

The Bottom Line

Selling short can be done in a myriad of ways. And, although naked short selling is often given a bad reputation in the media because it is frequently abused, it is not as nefarious as its critics suggest.

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