What is Naked Short Selling and Why is it Risky?
Naked short selling is a high-risk trading practice where traders sell shares they do not own or have not borrowed, aiming to buy them later at a lower price to cover their position. While traditional short selling requires borrowing the shares first, naked shorting skips this step, which significantly increases both the risk and potential gain. This practice has been largely banned due to its market destabilizing effects.
Key Insights You Need to Know
- Illegal in the US and EU: Naked shorting is generally illegal and highly regulated in many financial markets, particularly in the US and the EU since the 2007-2008 financial crisis. The SEC has strictly enforced transparency and borrowing requirements to clamp down on the practice.
- Market Impact: This unregulated selling can distort the supply and demand of a security, leading to price manipulation and increased volatility. It contributes to an environment that is unfair and deceptive to retail and institutional investors alike.
- Potential for Significant Financial Losses: Participants engage in naked short selling at great risk, as market movements can lead to a scenario where shares cannot be sourced to cover positions, resulting in a failure to deliver (FTD).
- Tools for Increased Transparency: With regulations like the SEC’s Regulation SHO, market regulators have implemented transparency and reporting mandates, helping to mitigate the unethical practices linked with naked short selling.
Understanding the Complexity: How Naked Shorting Works
When engaging in naked short selling, a trader sells shares without borrowing them or ensuring their availability. Risk here multiplies because the trader assumes they can later buy the shares at a lower price. If everything goes well, they lock in a profit. But if the share price rises instead, the trader faces unlimited losses with no guarantee of getting the shares to cover up sold positions.
Let’s break this down with an example:
Imagine you short sell 1,000 shares of Company A without borrowing them, banking on the price falling. If the price of Company A’s stock drops before the covering position, you buy the shares at this lower price and close the deal for a profit. However, if the price increases, procuring 1,000 shares could lead to substantial losses and possible failures in delivering the assets.
Example of Naked Short Selling: Simplified
- Initial Step: Sell 1,000 shares of Company A without borrowing.
- Expected Outcome: Company A’s share price drops.
- Cover Position: Buy 1,000 shares at the lower price and fulfill the short position with a profit.
- Adverse Scenario: Share price rises, requiring more capital to cover 1,000 shares, causing significant losses. One possible outcome is an FTD due to the shortage of available shares.
Market Implications: More Than Just Numbers
By allowing traders to create stocks artificially, naked shorting often contributes to artificially depressed stock prices. The false sense of liquidity created through such trades could manipulate market participants into believing in a misrepresented stock supply. These deceptive tactics are one reason behind tight regulations against naked short selling globally.
Is Naked Short Selling Legal?
In the US, naked short selling is illegal due to regulatory measures enforced by the SEC since the peaks and pitfalls of the 2007-2008 financial crisis. The SEC’s Regulation SHO implements comprehensive policies that require broker-dealers to ensure that shares can be borrowed before short selling. Regulations and banned practices vary worldwide. While European Union laws enforce similar constraints through organizations such as ESMA, countries like Japan, Hong Kong, and the United Kingdom uphold their own stringent rules to counter naked short selling practices.
Historical Context and Infamous Instances
Short selling, even beyond its ’naked’ counterpart, often incites public outrage as it involves profiting from an entity’s decline. Notable cases include Lehman Brothers’ collapse in 2008, which displayed marked increases in failure-to-deliver shares, suggestive of intensive naked short selling. The GameStop saga of 2021 further highlighted concerns, revealing how massive short positions, regulatory loopholes, and concentrated stock tactics create volatility not limited to traditional stocks.
Preventing Abuses: Uplift in Regulations Over Time
Outlawing naked short selling has prompted critical changes. Regulations have consistently evolved, calling for increased transparency, true dealt stocks, and eliminating loopholes to protect the market. SEC’s addition of more robust measures in recent years reflects a global commitment toward creating accountable, efficient trading environments.
Common Queries Clarified
Q: What is short covering?
Short covering involves buying back a previously short-sold security to close the open short position—either capturing a profit or mitigating a potential loss.
Q: How does a short squeeze occur?
A short squeeze happens when a stock’s upsurge forces sellers with short positions to buy back shares to close positions, further driving the price upward and causing extensive losses to short sellers.
Q: Explain securities lending:
Securities lending allows the owner of securities to lend them in exchange for collateral and a fee, enabling the borrower to participate in short selling and other trading strategies.
Q: What are options like covered calls?
Covered call writing refers to holding a long position on an asset while selling call options on it to generate additional premium income. The approach cushions market downturn impacts with enhanced total position yields.
Q: What constitutes a synthetic short forward?
A synthetic short forward replicates the positions of a short forward using options, benefiting traders who expect asset price declines without directly short selling.
Final Takeaway
Naked short selling presents a volatile, unethical canvas rampant with repercussions. By trading in non-existent shares and inducing abnormal market behavior, its legality is generally nonexistent within prominent financial sectors. Regulation SHO by the SEC and parallel rules international safeguard markets by redefining transparency and fair play standards. Considering such frameworks provides clarifiability and security to trading spectra confronting generational evolutions in diversified stockholding dynamics.
Related Terms: Regulation SHO, market volatility, short squeeze, securities lending, synthetic short forward.
References
- Securities and Exchange Commission. “Key Points About Regulation SHO”.
- Yahoo!Finance, “If Naked Short Selling is Illegal, How Is It Still Being Done?”
- James J. Abgel and Douglas M. McCabe, “The Business Ethics of Short Selling and Naked Short Selling”
- Tālis Putniņš. “Naked Short Sales and Fails to Deliver: An Overview of Clearing and Settlement Procedures for Stock Trades in the US”. *Journal of Securities Operations & Custody.*2/4 (2009-10). Pages 340-350.
- Steven Lecce, et al. “The Impact of Naked Short Selling on the Securities Lending and Equity Market”. Journal of Financial Markets. 15/1 (2012). Pages 81-107.
- U.S. Securities and Exchange Commission. “Practices Related to Naked Short Sale Complaints and Referrals”, Pages i, 11-12.
- Reuters. “New US SEC Rules to Shine a Light on Short Selling”.
- Reuters. “FACTBOX: Milestones in Short Selling History”.
- Chinmay Jain, Pankaj K. Jain, Thomas H. McInish. “The Handbook of Short Selling”. Springer Nature, 2012. Chapter 5.
- Financial Times . “Fuld Says Lehman Victim of Short Sellers”.
- Veljko Fotak, Vikas Raman, Pradeep K. Yadav. “Fails-to-Deliver, Short Selling, and Market Quality”. Journal of Financial Economics. 114/3 (2014). Pages 493-516.
- Zaghum Umar, et al. “A Tale of Company Fundamentals vs. Sentiment-Driven Pricing: The Case of Gamestop”. *Journal of Behavioral and Experimental Finance.*Vol. 30 (2021).
- Yahoo! Finance. “If Naked Short Selling Is Illegal, How Is It Still Being Done?”
- ESMA. “Short Selling”.
- Financial Conduct Authority. “Short Selling”.
- Financial Services Agency. “Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.”
- Hong Kong Securities and Futures Commission. “Short Position Reporting Service- User Guide (for March 2017 onwards)”.
- Australian Securities and Investments Commission. “Short Selling”.
