The topic of naked shorting reared its, ahem, head recently for the first time in quite a while. It was a top trending topic over the past couple of days. For those of you who either were caught up in the online debate or watched it from the sidelines, it seems useful to offer a refresher about the mechanics of short selling.<\/p>\n\n\n\n
Let me start with a reminder \u2013 short selling is legal, ethical, and a necessary lubricant to the smooth functioning of the market. The practice certainly has a bad ring to it \u2013 selling shares that you don\u2019t own with the hope and\/or expectation that the price of the stock will decline. It runs counter to everything we are told about why we should invest. The dogma is that we want to be investing in quality companies to participate in their growth, and that buying shares of undervalued companies is a path to long-term success. There is certainly truth to that statement, but why wouldn\u2019t the opposite be true? If there is money to be made from buying under-valued stocks, shouldn\u2019t there be money to be made from selling over-valued stocks? That is the bet that a short seller is taking.<\/p>\n\n\n\n
Short sellers know, or at least should know, that they are taking on exceptional risks when shorting. For starters, the risk\/reward is skewed against them. Stocks can only fall to zero, but can rise infinitely. Furthermore, all short sales require borrowed shares. Remember, whomever is on the other side of a short sale expects to have shares delivered on settlement. The short seller borrows shares to facilitate delivery, and anytime you have to borrow something (money or shares) you have to assume the liability for repayment. Thus, by definition, short selling is done with margin and riskier than a cash purchase. (I explained much more about the stock borrowing process in this article.<\/a>)<\/p>\n\n\n\n If the odds are against the short seller, why do it? In the case of a speculative short, the sellers have a strong conviction that the risk\/reward is in their favor. Hopefully they understand the risks, not only that the stock might rise but also that the cost or availability of their borrowed shares can move adversely. But there are many relatively benign and even market-friendly reasons for short sales. Index arbitrage is one. If there is aggressive selling in index futures or ETFs, an arbitrageur will attempt to sell the index composition \u2013 often short \u2013 against buying the futures. This activity uses short-selling to stabilize the market. The ability to short index components allows them to place bids in the plunging futures or ETFs. Markets become much less liquid and more volatile if that feature is inhibited. The same is true for ADRs and inter-listed shares. If there is excessive demand or supply in one marketplace, short sellers can help balance the flows. Market makers find themselves selling short all the time. They are required to make continuous two-sided markets and they are not always long the shares that someone wants to buy. Again, this is beneficial to the smooth functioning of the marketplace.<\/p>\n\n\n\n Naked shorting \u2013 the practice of selling short without properly borrowing shares — came back into the public debate last week, largely because of a blurted comment by a CNBC host. During a segment on CNBC\u2019s Fast Money, Melissa Lee blurted out \u201cnaked shorting, yeah\u201d during comments made by Tim Seymour. (It\u2019s at the 1:40 mark of this clip<\/a>). The internet took that as evidence of nefarious activity. It is not. A three word utterance by a TV host, treated as a non-sequitur by her guest, is not even close to offering proof that a conspiracy of naked shorting is occurring en masse.[i] <\/p>\n\n\n\n Naked short selling is generally illegal[ii], and brokerage firms typically go to great lengths to prevent their customers from selling shares short without first determining whether they can borrow the shares on the customer\u2019s behalf. Obviously because something is illegal and discouraged doesn\u2019t mean that it isn\u2019t going on somewhere. I can\u2019t prove that naked shorting isn\u2019t occurring at all. But I can assert with reasonable assurance that it is uncommon at most. It is simply not worth the trouble for compliant brokerage firms to allow it. <\/p>\n\n\n\n I suspect that some people are confusing naked short sales of stock with naked options selling. The latter activity is legal. I suspect that some of the confusion stemmed from this Bloomberg article<\/a> with the following quote from a Jefferies corporate memo: \u201cUntil further notice, Jefferies Prime Brokerage will no longer offer custody on naked options in GME, AMC and MVIS\u201d. Naked options selling can be a very risky activity, but is fundamentally different than selling stocks short. Remember, when you short a stock you are required to locate someone who will lend the shares to you. Naked options don\u2019t require a borrower. As long as your broker believes that you have sufficient margin to cover your risk, the only requirement for shorting an option is finding a buyer. You are not exchanging a security, you are exchanging the right, but not the obligation to buy or sell shares. That sale is guaranteed by the Options Clearing Corporation (OCC), not by a stock lender. It is a seemingly minor distinction, but a crucial one. <\/p>\n\n\n\n While we\u2019re clearing up some internet information about naked short selling, we might as well clear up another source of misunderstanding. This concerns the ability to withhold stock lending. There are many meme stock investors who want to avoid lending their shares to facilitate short selling. I understand the impulse \u2013 it is understandable why a committed investor would want to discourage those who bet against their holdings \u2013 but I question the logic. If much of the rally in meme stocks can be attributed to short squeezes, one might prefer to encourage shorting. That said, visceral impulses have propelled meme stocks, so I respect the holders desire to clamp down on the activity. There is only one way reliable way to do that.<\/p>\n\n\n\n If you hold fully paid shares in AMC or another meme stock and don\u2019t want those shares lent, you need to move them to a cash account and inform your broker that you don\u2019t want to lend them. If you hold the shares in a margin account, even if they are fully paid, they are actually held by your broker on your behalf. That is often called \u201cstreet name.\u201d Shares that are held in street name can be lent by the broker who holds them, and we can be certain that a broker would be eager to lend hard-to-borrow shares at a highly favorable rate. If you own the shares in a cash account, the broker can\u2019t lend your shares without your permission. That is it. There are incorrect suggestions floating around the internet. A popular one says that if you use limit orders, your broker can\u2019t lend your shares. That is ridiculous. Stock loan is part of the clearing process, not the trading process, and how an order was placed has no bearing upon what happens after the trade is executed. <\/p>\n\n\n\n Many have described the trading in meme stocks as a mania. I don\u2019t disagree with that description. The level of hyperbole, enthusiasm, and yes, misinformation, has moved the activity in this eclectic group of stocks from normal investing to something beyond. My goal throughout this process has been to provide facts that can help investors understand the mechanics behind the mania. Opinions can be debated, but the debate is much more productive when it is factual.<\/p>\n\n\n\n GameStop Showed Short Interest > Float. How Could That Be? – Traders’ Insight (tradersinsight.news)<\/a><\/p>\n\n\n\n —<\/p>\n\n\n\n [i] Full disclosure \u2013 I have appeared on Fast Money with Melissa Lee.\u00a0 The appearance was remote, so I\u2019ve never met her or the panelists in person.\u00a0 I have no reason to defend them if I felt they admitted something incorrect.\u00a0<\/p>\n\n\n\n [ii] While abusive short selling is illegal, naked short selling is not always abusive or illegal. The Securities and Exchange Commission (SEC) recognizes that there are circumstances under which naked short selling is not a violation of securities law. See this website<\/a> and this website<\/a> from the SEC for their guidance.<\/p>\n","protected":false},"excerpt":{"rendered":" Naked shorting \u2013 the practice of selling short without properly borrowing shares — came back into the public debate last week. However, Steve Sosnick wants to clear up some popular misconceptions.<\/p>\n","protected":false},"author":4,"featured_media":47191,"comment_status":"closed","ping_status":"open","sticky":true,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[14,17,14700,6,19,8,9,20,22,26,3],"tags":[9853,4496],"contributors-categories":[13576],"class_list":{"0":"post-90959","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-etfs","8":"category-futures","9":"category-ibkr-market-insights","10":"category-north-america","11":"category-options","12":"category-region","13":"category-securities","14":"category-short-selling","15":"category-stocks","16":"category-text-articles","17":"category-traders-insight","18":"tag-naked-shorting","19":"tag-short-selling","20":"contributors-categories-interactive-brokers"},"pp_statuses_selecting_workflow":false,"pp_workflow_action":"current","pp_status_selection":"publish","acf":[],"yoast_head":"\n