Naked Short Selling

Naked Short Selling Explained

9 min read

Are you into 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, I am not making sure it can be covered. Before you get excited, I suggest you hunker down and take a read; it might save you a trip to the Crowbar Hotel.

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 the price has fallen. Then, you get to keep the difference between when you bought and when you sold. And the shares go back to the broker/lender. 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.

When GameStop happened, this was 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.

5 Second Takeaway

  • Naked short selling is the criminal case of short selling without first determining whether the shares exist or are borrowable. 
  • A sudden rise in 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.”

Normal Short Selling

Short selling is a trading technique by which you make money from a stock 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’ll need a broker that allows it.

Naked Short Selling Steps

  1. Borrow the shares from their owner or your broker.
  2.  Sell and deliver the borrowed shares 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.
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Has the US Ever Banned Short Selling?

In 2008, the US banned short selling of financials for some time because they thought it contributed to the crash. However, that was not true when more research and studies were done. Prices still fell even with shorting not allowed.

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

Example of a “Normal” Short Sale

Suppose you think TSLA, currently trading at $840, will tank because the government prohibited space travel. Rumors say the price can fall to $200. Can anyone in their right mind 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 must 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 of 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 at the bank. Naked short selling is a little different.

Naked Short Selling Example

Naked Short Selling Example

This is an example of naked short selling on the ThinkorSwim platform.

Defining 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. Finding shares to borrow can be difficult if the stock is in short supply. Ultimately, a “fail to deliver” scenario results.

What Is a Failure to Deliver (FTD)?

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

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

Engaging 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 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 not check whether the shares are available or even borrow them first? 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 2014, the SEC they charged two Florida State University professors, Gonul Colak and Milen Kostov, 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. Moving a short position from one brokerage firm to another every few days, they spread the failures, avoiding detection.

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

Big Brother is always watching and noticing 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 of options trading in a different company. Cross-referencing their findings and crunching blue sheet data made it clear that Colak and Kostov were likely trading with one another. 

Failures to Deliver With Regulation

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

More importantly, the broker or dealer must first borrow or identify the stock being sold BEFORE accepting the short sale order.

Further, any stocks bought and sold in a transaction must be settled within two days. 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, a.k .a. naked short selling? They do this t to purchase back the stock at a lower price and deliver it later. 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.

Final Thoughts: Naked Short Selling

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.  

Luckily, we have thousands of dollars of free courses and videos to get you started. If you’re looking for advanced strategies, our “Deluxe Yearly Membership” will give you access to golden training nuggets. 

 In our “next level training” video library, you’ll receive our exclusive trading content that would cost you a lot of money with other trading companies, either in high-end trading courses or private coaching sessions.

Don’t sell yourself short. Save your money with Bullish Bears and get the training and coaching you deserve.

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