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This week’s Unplugged article is a quick one. We have Tropical Storm Fay bearing down on us as I write and the power is already starting to flicker here in South Florida.
I received several emails about the concept of naked short selling and apparently there is still some confusion about the subject.
I enjoy your columns, and while I frequently agree with your thoughts and theories, sometimes I find it hard to follow your ideas. Can you define more precisely "naked short selling"? I think I know what you mean, but want to be certain.
As a novice investor, I didn't quite understand the difference between a naked short and a normal short. Shorts are confusing enough for beginners (for instance, why must the shares be borrowed?)
So, very humbly, I might suggest a few extra sentences in this article to explain what a naked short is, comparing it to a regular short.
I have struggled with how to explain this concept in simple terms for some time now. When family and friends hear these terms and want to gain a better understanding of what is going on, I always try to accommodate them and explain it in terms they will understand. But the idea of selling short and the concept of naked short selling is an area where I continue to struggle.
Here is the best I can do. Say you agree to buy a car and you give the seller the money and expect to receive the title in three days (the same amount of time you have to deliver a stock you have sold). But it turns out the seller isn’t really the owner. The car you thought you just bought doesn’t exist. Seems rather crooked doesn’t it?
This is the equivalent of what the naked short sellers are doing. They are selling shares they don’t own and not delivering the shares within the three-day period they have to deliver them. They are essentially counterfeiting shares of company stock.
On a regular short sale, the seller is selling something they don’t own, but then they go out and borrow the shares from someone that does own them. The seller pays interest in the way of margin for borrowing someone else’s shares and this is all perfectly legal.
The second area where I received feedback was the ramifications should the SEC suddenly start enforcing the rules regarding naked short selling.
It seems to me that if a hedge fund is naked short and they are "forced" to close, then what they will do is buy back their short position (and I assume at a profit). Why do you assume that they will lose money? Why would they be forced to sell assets "in order to cover the naked short?" Wouldn't they just buy back the short at a profit?
As the naked shorters cover, won't the small companies rise in price (as their stock is bought)? And would not the profits from that short covering be put into the larger companies, and wouldn't their stock rise as well?
First, I want to say that this is a theory of mine and not anything I have heard or read somewhere else. But here is how it would work… the short sellers would have to buy the shares that they sold that didn’t exist. They may very well be at a profit right now, but if they were all forced to buy back shares all at once, the buying pressure on these shares would be phenomenal. What was a profit would disappear very quickly as hundreds of institutional buyers enter the market trying to buy enough shares to cover their short position. And remember, these are real shares not counterfeit shares.
Since most hedge funds are paid on performance, the don’t typically keep cash laying around to buy these shares, so they would need to sell “real shares” to raise capital.
So my theory is that small companies that have been the focus of the naked short selling would ramp up dramatically, while large-cap stocks with huge institutional ownership would fall.
Again, this is just a theory of mine and it is something the SEC needs to think about before they act too hastily.
Good Luck and Good Trading,
P.S. To let me know what you thought of today's article, send an e-mail to: firstname.lastname@example.org.