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.
- Naked short selling occurs when you sell short without having properly located and borrowed the shares to be sold.
- To sell short, you normally have to borrow existing shares from your broker or clearing firm.
- Naked shorting is illegal per Regulation SHO and can lead to a failure to deliver (FTD).
Shorting Without Failing to Deliver
There is another form of short selling, sometimes called a synthetic short. This involves selling call options 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, a type of equities derivative not traded in the U.S. since 2020.
Prepaid forwards and swaps are sometimes used to carry out short sales; however, these are done directly between the customer and a 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 their 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, they need not borrow shares and instead collect all of the interest on the proceeds for themself.
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. Their 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.
Naked short selling was criticized by some in the news media who claimed 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 collapse of Bear Stearns and Lehman Brothers show that there is an explanation for those large volumes; however, that strategy did not cause the collapse of those companies.
When Should You Not Short Sell?
It is recommended that new traders do not short sell as it is a much more involved and risky type of strategy that comes with a variety of rules. Only experienced traders should attempt to short sell and only when they have done the required research to justify their positions.
What Triggers a Short Sale Restriction?
Short selling a stock is restricted when the stock's price drops 10% or more than the previous day's closing price. The rule was implemented by the SEC to preserve market confidence and efficiency.
How Long Should You Hold Onto a Short Sell?
Traders should hold onto a short sell for as long as that trade is profitable. Once the trade stops being profitable, or, more likely, starts to move away from being profitable, the trader should close out their short sale.
The Bottom Line
Naked short selling is risky and not allowed, yet continues to happen in the market place. Traders and investors should always trade in a manner that takes risk into consideration while employing safety measures in their trades.
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