(Naked) Short Selling

Definitions

• Definition of Short Selling from Investopedia:

  The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.

  Selling short is the opposite of going long. That is, short sellers make money if the stock goes down in price.

  This is an advanced trading strategy with many unique risks and pitfalls. Novice investors are advised to avoid short sales.

• Definition of Naked Shorting from Investopedia:

  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. But due to various loopholes in the rules and discrepancies between paper and electronic trading systems, naked shorting continues to happen.

  While no exact system of measurement exists, most point to the level of trades that fail to deliver from the seller to the buyer within the mandatory three-day stock settlement period as evidence of naked shorting. Naked shorts may represent a major portion of these failed trades.

  Naked shorting is illegal because it allows manipulators a chance to force stock prices down without regard for normal stock supply/demand patterns.

  In 2007, the Securities and Exchange Commission (SEC) amended Regulation SHO to further limit possibilities for naked shorting by removing loopholes that existed for some broker/dealers. Reg SHO requires lists to be published that track stocks with unusually high trends in "fail to deliver" shares. Some analysts point to the fact that naked shorting, albeit inadvertently, may help markets stay in balance by allowing the negative sentiment to be reflected in certain stocks' prices.

Related articles

• An article on The Register
  • Comments on that article:

    Shorting, for those that don't know it is the business if borrowing company stock from someones in exchange for collateral such as cash, bonds, other shares etc. and selling them on the open market. The idea is that you do so, wait a while as the stock goes down and then buy the same number of shares back at the (now) reduced price, return them and get your collateral back. The difference in price is your profit.

    Doctor Overstock's beef is against people who sell the stock without doing the "borrowing in exchange for collateral" bit. The reason being that he thinks that people doing so will sell their stock at a lower price than the "unsullied" market and so the price of the stock (which, it's worth repeating is simply the mid-point of the highest registered bid for <x> amount of a stock and the lowest registered offer for <y> amount of stock. x and y have no relation) will drop, depressing the value of the company.

    [...]

    Remember: You can't sell something unless someone buys it. It takes two parties to perform a transaction, willing and aware. Neither enters in to it unless they belive that they will profit from doing so.

    No-one loves someone who profits from misery, but that doesn't change the fact that shorting is perfectly legitimage business.

  • Another comment:

    You are right when you say you cant sell something unless someone buys it. However, you can sell something you don't own. This is normally called fraud, but is usually, or has been usually overlooked in the case of naked short selling.

• Article on Wikipedia:

  Naked short selling is a case of short selling the shares without first arranging a borrow. The Securities Exchange Act of 1934 stipulates a settlement period up to three business days before a stock needs to be delivered, generally referred to as "T+3 delivery."

  Naked short selling [...] can contribute to market liquidity

  However, naked shorting to drive down share prices violates US law. In recent years, a number of companies have been accused of using naked shorts to profit at the expense of shareholders. To do this, the trader simply enters a naked short with no intention of ever delivering the shares. A large enough short sale could cause the price to fall, as is the case with any stock being sold. As long as the trade is large enough to move the share price, the short sale is likely to be profitable.

  The short seller is vulnerable to a "short squeeze." That is the condition where the stock price unexectedly (from the short sellers' point of view) rises and short sellers try, all at once, to close out their money-losing short positions by buying back in the open market the shares they had shorted, thereby driving prices ever higher in a self-reinforcing feedback loop.

Summary

• Stock price is mid-point between highest registered bid and lowest registered offer.
• Naked shorting can improve market liquidity (ie. reduce the gap between bid and offer), which is good.
• Naked short sellers may drive market down because they take less risk than short sellers (who are vulnerable to the "short squeeze"). They keep the option to "fails to deliver". They can "conspire" to drive market price down.