What Is Naked Short Selling?

Naked short selling. No, it’s not someone who trades in their birthday suit. And no, it’s not something you should aspire to model, even though I’m sure you look great in your birthday suit. It’s trading stock without borrowing it ahead of time. Therefore, not making sure it can be covered. Before you get all excited, I suggest you hunker down and take a read, it might just save you a trip to the crowbar hotel.

Can Short Selling Be Banned?

When GameStop happened, this is the first we heard of short selling. It caused a lot of people to figure out what shorting was. As a result, people want it to be banned. Naked short selling is one way of shorting that is illegal. Shorting is one way to make money in a bear market. It can take a bad rap and bear the blame for crashes. But when used right, it can keep you trading in a downturn.

Naked Short Selling 5 Minute Takeaway

  • Naked short selling the criminal case of short selling without first determining the shares exist or are borrowable. 
  • A sudden rise in the number of fails-to-deliver will alert the SEC to the possibility of naked short selling.
  • Naked shorting tends to happen when shares are difficult to borrow.
  • Some companies have been accused of using naked shorts in aggressive efforts to drive down share prices.
  •  The practice dilutes a company’s shares, artificially depressing the share price.
  • The SEC “has zero tolerance for abusive naked short-selling.”

What Is “Normal” Short Selling?

Short selling is a trading technique by which you make money from a stock that’s falling in price. Short selling is a form of speculation in which a trader takes a “negative position” in a company’s stock.

In a nutshell, the short seller sells shares without owning them. They later purchase and deliver the shares for a different market price. Not every broker allows shorting, however. So if you’re going too short, you’re going to need a broker that allows it.

Step-By-Step Approach

  1. Borrow the shares from their owner or your broker
  2.  Sell the borrowed shares and deliver them to the buyer who becomes their new owner. 
  3. The short seller closes his short position by purchasing the same number of shares in the market and returning them to the lender.

Has the US Ever Banned Short Selling?

Back in 2008, the US banned short selling of financials for a period of time because they thought it contributed to the crash. However, when more research and studies were done, that was found not to be true. In fact, prices still fell even with shorting not allowed.

So short selling was allowed again. In fact, in 2011 when the market was correcting, stocks with a shorting ban fell more than stocks without the ban. Naked short selling still isn’t legal though.

A Real-Life Example of a “Normal” Short Sale

Naked Short Selling

Let’s assume you think TSLA, currently trading at $630, will tank because the government just prohibited space travel. Rumors’ are the price can fall to $200. Anyone in their right mind can see the haircut portfolios will take with the gap down $430?

But, what if there was a way you could profit from the fall? That’s where short selling comes into place. Even if you don’t own shares because you can’t afford them, you can borrow them. It’s akin to renting something, you get to use it, but you need to return it.

 In our case, we “borrow” the shares from our broker. Our broker then borrows the shares from someone who owns them with the promise that they will return them later. 

Based on your research, you borrow or sell “short” 100 shares TSLA at $630. Sure enough, the price falls back to earth and lands at $200. You repurchase them at the bargain-basement price of $200. You then return them to your broker, covering your position while your broker returns them to the lender.

When the dust settles, you’re laughing all the way to the bank. Naked short selling is a little different.

How Do You Define Naked Short Selling?

 Naked short selling, or naked shorting, is when any tradable asset (stocks, commodities, futures) is shorted without first:

  •  owning it,
  •  borrowing it from someone -like a broker, or,
  •  ensuring it can be borrowed

Unfortunately, one of two scenarios can happen: The short seller cannot afford the shares, or the shares aren’t available to purchase back. If the stock is in short supply, finding shares to borrow can be difficult. Ultimately, a “fail to deliver” scenario results.

What Is a Failure to Deliver (FTD)?

In the world of finance, a FTD is the inability of a party to deliver the tradable asset they committed to. A typical example we see in the stock trading world is the seller’s failure to provide shares as part of a short transaction. 

If you’re nosey like me, you can see all the US “fails-to-deliver” data on the Securities and Exchange Commission (SEC) website. Click here

Short Selling Explained

Short selling borrows shares from a broker or lender at one price and then buys them back at another. This is a bearish play because you cover after price has fallen. Then you get to keep the difference of when you bought to when you sold. And the shares go back to the broker/lender. In fact, you never really own the shares at all. Naked short selling is different because there’s no way of knowing if shares even exist to cover.

Why Would Traders or Companies Engage in Naked Short Selling?

For years, the rationale behind naked short selling has been disputed. Some studies have shown that naked shorting happens when shares are hard to borrow. Other studies show that it increases the cost of borrowing. 

More alarmingly, some companies have been accused of naked short selling in an attempt to drive down share prices. More alarmingly, some have no intention of ever delivering the shares. With a surplus of “fake” shares for sale, the market would be flooded, driving down prices. 

Why would a seller decide NOT to check to see the shares are available or even borrow them first? To be honest, it seems somewhat reckless to me. However, in some cases, lenders aren’t available or, the lending costs are too high. So naked short selling happens.

Illegal Naked Short Selling In Action

In 2014, Two Florida State University professors, Gonul Colak and Milen Kostov were charged by the SEC for using a naked short selling strategy, netting them over $400,000 in revenue. 

They repeatedly engaged in a series of sham transactions over 20 companies, perpetuating a naked short position as part of an elaborate options trading scheme. Colak and Kostov failed to deliver the securities underlying their short positions within three days.

But, their sham created the illusion that they had provided the securities. All the while, they had taken no steps to do so, maintained the uncovered naked short positions, and profited. How did they do it? 

For starters, they used multiple brokerage accounts to disguise their shady transactions. By moving a short position from one brokerage firm to another every few days, they spread the failures out, avoiding detection.

Secondly, they purchased and wrote two pairs of options on the same underlying. They made sure to target options in securities that were hard-to-borrow where the price of the put was higher than the call option. 

Big brother is always watching and noticed unusual trading in one of the companies whose options were being traded by Colak and Kostov. In a separate investigation, an SEC examiner noted Kostov’s large volume options trading in a different company. By cross-referencing their findings and crunching blue sheet data, it became clear that Colak and Kostov were likely trading with one another. 

Preventing Failures to Deliver With Regulation SHO

Naked Short Selling

To prevent Failures to Deliver and target abusive naked short selling, the SEC passed Regulation SHO in January of 2005. It focused on limiting the time a broker can permit failures to deliver.

More importantly, it required that the broker or dealer have first borrowed or identified the stock being sold BEFORE they accepted the short sale order.

Further to this, any stocks bought and sold in a transaction must be settled within two days. And the buyer must give the cash to the seller, and the seller provides the stock to the buyer. 

Deliberate Fails-To-Deliver

Did you know that some people deliberately trigger an FTD to profit from falling stock prices, aka naked short selling? They do this to then purchase back the stock at a lower price and deliver it at a later date. One historical example was just the failure of Bear Stearns.

During the week of March 10th, 2008, failure-to-deliver skyrocketed 10,800% just before Bear Stearns collapsed. 

Interesting Failure-To-Deliver Facts

  • During September 2011, fails-to-deliver had reached $200 billion a day. 
  • Greater FTDs lead to higher liquidity and pricing efficiency.
  • The Journal of Financial Economics found no evidence that FTDs “caused price distortions or the failure of financial firms during the 2008 financial crisis.”

Naked Short Selling Final Thoughts

Naked short selling is the illegal practice of short-selling shares that have not been affirmatively determined to exist. On the flip side, we have short-selling, which is a great way to make significant profits. This type of trading is a very complicated game, and you don’t want to find yourself on the wrong side of a trade.  

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