Investing > Naked Short: Explained

Naked Short: Explained

Naked short selling is a method of market manipulation that ultimately skips the first step of shorting a stock.

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Updated January 08, 2022

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Can you sell something that doesn’t exist? 💭

Gregor MacGregor certainly thought so when he was selling non-existent treasury bonds of his fictional country in the early 1900s in the UK and France. Naturally, he was leading a hundred or so of his investors to an early grave—and arguably, those that engage in naked short selling are doing the same to this very day. 📅

Naked short selling involves selling shares that have not been proven to exist in the first place. It has a sinister reputation, and depending on the opponent, is often viewed as anything from ‘somewhat questionable’ to ‘downright fraudulent’.

One of its loudest, and best-informed critics is Susanne Trimbath, Ph.D. who, in her book—Naked, Short and Greedy: Wall Street’s Failure to Deliver—made the case that naked shorting is a fraud and should be banned and penalized as such. She has gone even further in a later interview stating that this practice wouldn’t exist in a more perfect world.

However, in the same interview she has expressed her support for regular shorting. This is a stance she shares with other experts who believe short-sellers are an integral part of the stock market, despite disapproval from certain groups of investors.

On the other hand, some believe that naked shorting also has a valuable place in a healthy economy, especially since its ban came after the collapse of Lehman Brothers in 2008.  While the fall of the financial giant was attributed to this particular practice, it has later been linked to other, arguably more serious problems within the company.

So, let’s dive right in and find out what naked short selling is, how it works, and who and why would further exacerbate the risks of regular shorting by putting it in a birthday suit.

What you’ll learn
  • What is Naked Short Selling?
  • Origins of Naked Short Selling
  • How Naked Shorting Works
  • Naked Short Examples
  • Impact on the Market
  • Benefits and Risks of Naked Shorting
  • Naked Shorting Rules and Regulations
  • Get Started with a Stock Broker

What is Naked Short Selling? 🤔

Naked short selling differs from ordinary shorting in that you are not merely selling stocks you don’t own, but stocks you haven’t even borrowed. This kind of trading has come under increasing scrutiny after the 2008 financial crisis which ultimately led to its ban in the United States.

Despite the SEC ban, naked shorting is still being practiced with companies like BTIG LLC finding themselves accused of it in 2021. This legislation applies only for naked short selling with other forms of shorting still being perfectly legal.

Essentially, short selling consists of borrowing stocks and selling them with hopes that their price will drop by the time they have to be returned to the original owner. Naked shorting on the other hand skips the borrowing—the seller lists the stocks either hoping they’ll be able to borrow them after the fact or sometimes even without planning to borrow them at all.

Either way, if the sold stocks aren’t borrowed in time they become failed to deliver. This is a state they can remain in for some time—three days as per regulations in the US before a fine is issued by the SEC. While this might look like a smoking gun for anyone trying to suppress the practice of naked short selling, it isn’t completely so—there are other reasons why shares might fail to deliver.

Since naked short selling is both illegal and appears sketchy at best, you might be wondering why anyone would resort to it. This kind of shorting carries some benefits especially if the shares you want to sell are hard, or expensive to come by—you could borrow them later when the price drops while still benefiting from the current high prices. 

Origins of Naked Short Selling 📜

While the staggering value of GameStop shares that have failed to deliver has certainly brought naked shorting back into the public eye, it is a far, far older practice. The first known naked short seller was a Walloon entrepreneur Isaac Le Maire.

Apart from being the father of one of the early circumnavigators and a person who has ventured and lost more than a million guilders—worth around $10.000.000—over his 30-year-long career, he also spent much of his life dealing and feuding with the Duch East India Company (VOC).

His attempt at naked short selling occurred in 1609 as a maneuver against the VOC. While at first successful, the monopoly charter eventually brought in the legislative muscle which drove many of La Maire’s friends into bankruptcy and severely financially damaged Isaac himself.

In case you like one-against-many stories, you’ll be glad to hear that La Maire ultimately did break the VOC’s monopoly, though this was only a symbolic victory—and one achieved by finding the passage into the Pacific by Cape Horn rather than by deft investing.

How Naked Shorting Works 💡

As we’ve established before, regular shorting involves borrowing and selling shares, usually with hopes that their price will drop by the time they have to be returned. On the other hand, naked shorting involves stocks that are neither owned, borrowed, and, for that matter, even confirmed to exist.

This means that you might choose to sell the stock of a certain company realizing that how its stock is priced is incorrect and about to adjust—drop in value. However, you also want to do this quickly so you don’t want to waste time by borrowing said shares. You would then offer to sell these non-existent shares while attempting to get a hold of some as soon as the price drops.

Another case you might want to do naked shorting is if you believe a company is about to go under. In this case, you would try to time the sale so that the issuer of the stocks you are selling goes bankrupt just after you finish the transaction—ensuring that you don’t get caught in your naked short selling.

How naked shorting works.
In essence, naked shorting means selling shares you don’t own via a contract that obliges you to buy and deliver the assets in the future.

Needless to say, naked shorting offers the potential for even higher gains than regular shorting, while boasting even higher risks as well—and that is without considering the legal trouble you might get into.

This means that while regular shorting can be done by anyone through a good broker for short selling, naked short selling is usually left to large financial institutions with a lot of money, experience, and an armada of lawyers. The key to naked shorting is the SEC regulation that states that all transactions have to be completed within three days lest a penalty is incurred.

This caveat means that there is a short window when you can close your naked position and hopefully come out on top. For a while after the rule’s introduction, market-makers were exempt as naked short selling was considered an important tool enabling them to generate liquidity, however, they were also ultimately included under the expansion of anti-fraud regulations

Either way, naked shorting tends to create the discrepancy where a lot of people have shares on paper that in reality don’t exist—these are called phantom shares. 

Naked Short Examples 📊

With about 1% of all trades failing to deliver on the stock market, you could expect naked short selling to be both widespread and easy to detect. This, however, isn’t the case. There are multiple reasons why a trade might fail to deliver, and since the vigilance of the SEC has its limits, it is likely that most naked shorts are never discovered.

One well-known example where naked shorting almost certainly happened is with the GameStop craze that began in late 2020—$359 million in GME shares failed to deliver. This is also possibly the most famous case of shorting going wrong as the sudden price increase reportedly cost short-sellers around $20 billion—which is a rather conservative number—the truth could be closer to high tens if not hundreds of billions.

Naked Short Examples
GME rapidly rose to 4,000% of its previous price at one point in 2021 and held at 1,200%. This percentage is equal to the short-sellers’ losses. Image by TradingView.

One older possible example of naked shorting happened in 2003 and involved Rhino Advisors Inc. which, on behalf of Sedona Inc, entered into short selling of shares that didn’t yet exist at the time of the trade which led to a fine of $1 million imposed by the SEC.

While these two cases—along with the fate of Isaac Le Maire four centuries earlier—might lead you to believe that naked shorting, and short selling in general, never pays, that is far from the truth. One of the most famous examples of profitable short selling came in 1992 when George Soros successfully bet against the British Pound.

He once again came on top in May 2021 when he shorted the stocks of Trainline among the concerns over the recovery of the transport industry after the covid-19 pandemic.

The Impact of Naked Shorting on the Market

As naked short sales are hard to detect, their true impact on the market is difficult to gauge. That being said, their primary function tends to be boosting the liquidity of shares. By creating a buzz around stocks through their listing, brokers, and dealers can generate interest which can lead to a greater volume of stocks as both the supply and demand increase.

Supporters of naked shorting tend to claim that this practice can lead to corrections of pricing of certain low-volume stocks, while its detractors claim this to be market manipulation. Additionally, whether you are selling a car, a house, a mug or shares, it is fraudulent if you don’t actually own them.

How naked shorting affects the market.
Naked shorting is considered a negative practice but can have a vitalizing effect on the market in the short term.

The polarization of the view on the naked shorting is well-exemplified by some strikingly different opinions coming from experts. Robert J. Shapiro, the former undersecretary of commerce for economic affairs has in 2005 claimed that naked short selling had by that point cost investors $100 billion—while John Hempton, the founder of Bronte Capital Management, has in 2009 assessed that the ban on the practice has cost the taxpayers at least a billion dollars.

Furthermore, the creation of phantom stocks that arises from naked shorting can artificially dilute the value of a company’s stock which can make life difficult for it and, in some cases, cause it to go bankrupt. Admittedly, this is conjecture as is often the case with naked shorting as it is hard to detect and accurately measure. 

Probably the highest-profile cases hinting at its killing companies have been the Lehman Brothers and Bear Stearns. In both cases, however, later investigations found that most naked short-selling happened well after the companies were already doomed, and thus, it played a small role in their failure.

Naked short selling can also potentially lose an individual investor a lot of money if the failure to deliver leads to cancellation if they have picked the right time to buy certain stocks—if the prices jump before the trade is canceled, a golden opportunity might be lost.

Benefits and Risks of Naked Shorting 📈

Naked short selling carries a lot of benefits of regular shorting—and pretty much all of its drawbacks. This is to say it boasts a potential for high returns, a possibility for leveraged investments, and the ability to hedge against other holdings.

On the other hand, it also carries the threat of limitless losses and is under threat of squeezes. This second danger of shorting is especially highlighted by the GME squeeze which caused Melvin Capital hedge fund to lose more than 53% of its AUM in January of 2021.

Advantages of Naked Shorting ❓

Naked shorting, however, has some benefits over regular short selling. First, it allows an investor to benefit from coming price drops even if they can’t get a hold of needed shares immediately. This can be useful even if the stocks are available for borrowing but time is of the essence—skipping this step in the beginning can, theoretically, help one sell at the best possible moment.

Additionally, if you happen to have a lot of capital, you could use naked shorting to artificially create a supply of certain stocks. This would, obviously, not only be an option solely for the richest among us, but also market manipulation and, therefore, highly illegal. Is it really fair to consider this an advantage? I guess it ultimately depends on who is asking.

Risks of Naked Shorting 💸

This brings us to the drawbacks—the first of which, rather obviously, is that you get in trouble with the SEC if you attempt it. That being said, there is a slight chance that with extreme luck, intentionally canceling a naked short sale could ultimately save you from huge losses.

If you make a naked short right before a major squeeze and then decide to not complete the transaction within the mandated three days, there is a chance that the penalty imposed by the SEC could be smaller than the losses you’d suffer from trying to close the trade.

On the other hand, chances for such an occurrence are so small that they can be simply written off as an impossibility. Thus, naked short selling carries both the risks of unlimited losses due to the obligation to deliver the sold shares and those of penalization imposed by the SEC.

This means that the practice is generally inadvisable and impractical with the only times it merits consideration being when you are absolutely certain you can borrow the stocks you are shorting within the required time.

Pros

  • Potentially very high returns
  • Ability to capitalize on a good price
  • Ability to trade with otherwise unavailable stocks

Cons

  • Banned by the SEC
  • Potential for unlimited losses
  • Triggers failure to deliver
  • Creates phantom shares

Naked Shorting Rules and Regulations 📋

Naked shorting has varying legal status all over the World with some countries outright making it illegal, others making it impractical and some taking no issue with it. Still, the biggest hits to the practice probably came in 2008 in the US amidst the financial crisis and in 2011 when Germany pushed for a Eurozone-wide ban. So, let’s take a quick look at the regulations in some of the World’s major markets.

Regulations Within the US 🇺🇸

The earliest regulation concerning naked shorting came in 1934 with the Securities Exchange Act of 1934 which stipulated the deadline of two business days for the delivery of stock.

The next time the SEC addressed the topic was in 2005 when they pushed for further limiting the time a trade could be failed to deliver to 13 days with the Regulation SHO. This regulation also created the Threshold Security List which would contain the names of all the companies which had more than 0.5% of their total outstanding shares in a failed to deliver state for more than five days.

In July 2006 the SEC continued to take naked shorting ever more seriously with a proposal to amend the Regulation SHO and moved on with the tightening of the rules in 2007. They removed the so-called grandfather provision which exempts failures to deliver predating the Reg SHO from its limitations.

The true crackdown came after the 2008 financial crisis and naked shorting’s alleged role in the collapse of the Lehman Brothers—first with emergency measures banning it, and later with permanent regulations.

The SEC’s crackdown has continued since then, for example, in 2013 they went after the Chicago Board Options Exchange for naked short selling.

Furthermore, regulation tightening and more vigilant oversight appear to be on the way as the SEC chairman Gary Gensler seems determined to go hard on shorting after the GameStop and Archegos sagas.

Regulations Outside the US 🗺️

Since South Korea has threatened to jail naked short-sellers already in late 2020 it goes without saying that the United States isn’t the only country with a problem with this phenomenon.

Other countries that put strict regulations on naked shorting include the Netherlands, Japan, India, Singapore, and Germany. It is noteworthy though that according to an IMF report from 2010, Germany’s regulations against this practice appeared to have failed.

Circumventing the Rules 📖

Since regular shorting already carries risks of unlimited losses, it is highly inadvisable if not completely impossible for any individual investor to attempt naked shorting. Generally, you should consider shorting only after gaining some experience on the stock market, and even then, you should keep in mind that ETFs are considered safer to short as they generally carry fewer risks than trading regular stocks.

That being said, it is possible to avoid trouble if you can finish a trade within the mandated three-day period as the regulations and penalties are mostly aimed against abusive naked shorting that intentionally lets sales expire and attempts market manipulations.

Furthermore, considering the sheer number of trades happening daily it is technically possible to stay under the SEC’s radar—this holds even more true if you can gain access to the so-called dark pools.

That being said, in the aftermath of GameStop and with the reliance of major companies on these private markets becoming more and more obvious, it is likely that more regulation and stricter oversight are on the horizon.

Conclusion 🎬

Naked shorting is, much like regular shorting, far simpler in concept than execution. Additionally, as pressure mounts on both of these practices, it is doubtful how much of a future they have as apart from the Redditors of r/superstonks and r/wallstreetbets, Elon Musk has been watching short-sellers’ fears in 2021 with glee.

Generally, despite the claims of market experts on the value of regular shorting and speculations that naked short selling might also have a place in stock trading, the beginning of 2021 might have heralded big changes in the way the stock market works with the power of mass online organization becoming evident. Only time will tell if dr. Susanne Trimbah is right and that the possibly coming total ban on naked shorting will lead us to a more perfect world.

Naked Short FAQs

  • Is Shorting Stock Illegal?

    Regular short-selling whereby you borrow shares and then sell them is legal. On the other hand, naked short selling in which you sell stocks you neither own, have borrowed, or are certain you can borrow is illegal and is a form of fraud.

  • Can I Short Stocks I Own?

    If you short stocks you own you are doing a so-called short sell against the box. You do this by selling your shares without actually closing your long position—usually to avoid triggering a tax event. For this reason, the practice has been strictly regulated and is no longer considered a valid way to defer taxes.

  • Why are Short Sellers Hated?

    Since short sellers are at the same time not universally despised and hated by a wide variety of people it is hard to tell the exact reason. Many people cite their general discomfort with profiting from failures of others—which is how short selling achieves returns—or just how akin to gambling it appears. Elon Musk, for example, hates them because he sees them as value destroyers.

  • Does Warren Buffett Short Stocks?

    When he was starting, Warren Buffett did short stocks. However, he has since stopped with this practice citing both that attempting to short carries far more risks than holding a long position, and that he doesn’t believe that any short he could do could be big enough to have a true impact on the value of his conglomerate.

  • How Can I Tell if a Stock is Being Shorted?

    While you can’t reliably tell if a stock is being shorted at any time, exchanges release data on shorting every third Monday of a month. In the future, it might be even easier to find out which stocks are being shorted as there are indications that the SEC will require more transparency on this practice. 

  • What are Phantom Shares?

    In a nutshell, phantom shares are shares that don’t exist only on paper. They are usually created when a naked short sale is in the failed to deliver state. This is because the buyer has these shares when it comes to the transaction documentation but the seller neither has them nor the ability to deliver them.

    Generally, phantom shares disappear if the transaction is successfully closed—the seller gets a hold of them and transfers them to the buyer. However, it is possible that they persist and cause problems both in the form of cancellations and diluting the value of existing shares.

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