Naked Short Selling Stripped

by Doug on Jul.28, 2009, under Equities

What is a short sale?

First, a short sale is when stock is borrowed from a broker and paid back at a later date. The hope is the stock is at a lower price at the later date.

Fred wants to sell short 100 shares of ABC. He tells his broker and the broker borrows 100 shares from someone who owns ABC promising to pay them back. Fred immediately sells the 100 shares of ABC at current market price, say $1000 total. In 5 weeks, ABC drops to $8/share. Fred buys 100 shares at $800 and repays the broker. He pockets the difference, $200, minus commissions.

What is a naked short sale?

A naked short sale is where you simply sell the stock short without owning it. The speculator sells the stock, which he does not have, hoping to cover by the settlement date. If the stock is not delivered within 3 days, it is known as fail-to-deliver. Naked short selling can generate countless sell orders, overwhelm buyers, thus driving the price down. Failing to deliver is like issuing new stock in a company without its permission. You increase the number of shares circulating in the market, which devalues a stock.

How has this been a problem?

Remember the fall of Lehman Brothers or Bear Stearns? During that debacle, 38 millions shares of Lehman were sold as naked short sales, driving the price of Lehman shares to practically zero. The shares were not delivered to the buyers on time. Bear Stearns was done in by naked short sales, too.

What has been done?

On July 27, 2009 the SEC banned naked short selling. Now before a trader sells a security short, he or she must first borrow the security, usually from a brokerage house (traditional short selling). Now there is no fail-to-deliver since the stock is “owned”. The SEC made permanent a temporary rule requiring brokerage firms to make good on failed deliveries on T+4 — the day after a fail.