What is Naked Short-Selling?

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What is Naked Short-Selling?

Q.: What is 'naked' short-selling?

A: Naked shorting is when an investor sells the shares without borrowing them first, agreeing to deliver them at a fixed time. The seller buys the shares once the price has fallen and before he has to deliver them to the buyer.

In essence, what investors do here is to sell on the basis that they do not need to provide stock for, say, 5, 10 or 20 trading days. This is known as a 'naked short', where you short with no way to deliver the actual share certificate.

For instance, if you sell a share you don't own you then have a certain amount of time, depending on the length of the T+ (E.g T+3, would be 3 working days) accounting period, to buy it back before the broker required the certificate on settlement. If the share declines in price in the interim, and you are able to buy the share back at a lower price, you then keep the difference. If, on the other hand, the share rises in price, you will have to pay more for the share than you originally received, i.e. so you would end up with a loss. The more time you have to settle the more time you have for the shares in the company to fall, allowing you to buy in physical stock with which to settle.

However, this is a very risky tactic, and can prove embarrassing, complicated and expensive, as well as being illegal in the USA. Indeed, there are very few agency (private client) brokers who will now deal with you on an extended T+ relationship.

Also, naked shorting causes problems as it can mean more shares are being bought and sold than actually exist. If sufficient people do this it can drive the share price down. We all remember the Plummer on the AIM market, who had twice as many shorts against his company, than the company had shares in circulation, that caught the market out and it was the punter who lost out, and it showed just what a fiddle naked shorting can be.

Also, profits from shorting when one actually deals in physical stock are subject to capital gains tax (CGT). Unless you are interested in shorting very small or illiquid stocks - particularly Ofex stocks - then there are much more attractive ways of shorting than dealing through a broker. The most convenient way to short sell is through a CFD or spread bet.

US hedge funds have been seen to be the worst hedge fund culprits and have been blamed for helping to bring down the share price of the now bankrupt Lehman Brothers. Naked Selling is illegal in the USA.

Q.: What about using a covered short to hedge against my core shareholdings going down in the short-term?

A: I trust you would want to do this as a hedge against your position in a downward movement and protect profits. You can do this but if you're worried your stock is going to go down, I'd just place a stop order to sell the stocks, then re-buy them later. Shorting against the box means you're always guaranteed to lose money, since you cannot gain any value, and you're paying double commissions (and possible margin maintenance).

Q.: But don't stocks tend to rise in the long run?

A: Maybe but what happens if you missed the days the FTSE or Dow dropped by some 3% or greater and manage to retain the gains the index made? What would happen if you practiced some form of risk management coupled with some basic technical analysis or macro trigger that would have kept you out of the market when it was clearly a bear market? The long-term impact of missing the worst days is staggering. If you invested $10 in the Dow Jones in 1928 and simply held it to the valuation period it would now be worth $479.21. If during that period you had missed the good months - defined as those with a return of 10% or bigger you would have a portfolio valued at $17.32. If you had missed the bad months with declines of 10% or over your investment portfolio would be worth some $44,100!!

Q.: I still can't understand 'naked' short-selling...

A: Ok, let's suppose you bought some shares on the market today, and tomorrow something happens that causes you to decide to sell them. That's fine, isn't it?

Actually, if you sell tomorrow, you're selling shares you don't own. You made the contractual agreement to buy the shares today, but assuming you traded on standard T+3 settlement terms, the shares and the money only actually change hands on Thursday. The reason for this 3 day settlement period is to allow time to deal with the fiddly operational side of share transactions: account transfers, registry instructions and so on. Tomorrow, you're still the legal owner of the money and the seller is still the legal owner of the shares. You're contractually obliged to exchange them on Thursday, but you haven't actually exchanged them yet - just as e.g. if you exchange contracts to sell a house, you're still the legal owner of the house until the day of completion, but contractually obliged to complete on that day.

So assuming it's OK for you to buy shares today and sell them tomorrow, it's OK for you to sell shares that you don't yet own, on the basis that you're contractually entitled to receive them before you have to hand them over to the person you sold them to (which happens when tomorrow's trade settles on Friday).

In other words, normal long-only trading doesn't actually use a "you can only sell shares you own" rule, but a "you can only sell shares you own or are contractually entitled to receive before your sale settles" rule. Broker accounts generally hide that from you quite effectively, presenting a near-perfect illusion (*) that you own the shares from the moment you buy to the moment you sell, but the reality is that your legal ownership runs from 3 days after you buy to 3 days after you sell.

The other important ingredient is the legal nature of a stock loan agreement. If you 'borrow' shares under such an agreement, it's not like borrowing a lawnmower from your neighbour, where your neighbour retains legal ownership of the lawnmower throughout and you merely get to use it for a while. Legally speaking, despite the 'stock loan' name of the agreement, it's not borrowing at all; instead, the 'lender' transfers legal ownership to the 'borrower' in exchange for the latter accepting various contractual obligations, typically including payment of an ongoing fee, the obligation to make good certain financial consequences of not owning the shares (such as not receiving dividends from the company), and the obligation to deliver the same number of the same type of share back to the 'lender' on demand.

In other words, basically the 'borrower' is buying legal ownership of the shares off the 'lender', but paying for them with those contractual obligations instead of the more normal share-selling contractual obligation to deliver cash on the settlement date.

The net result is that the short-seller who 'borrows' shares under a stock loan agreement and sells them is selling shares he or she does already legally own, or at least is contractually entitled to receive before the sale settles. The legal ownership position is little different from that of the long-only investor who sells not long after buying, and so it is hard to make a convincing case that they're 'selling shares they don't own' any more than that investor is.

(*) The main imperfection is that if you wish to sell and withdraw the sales proceeds from the account, you'll generally have to wait until the trade settles - brokers generally won't hand out cash they haven't actually received yet!

The simplest form naked short selling involves buying the shares back later the same day in which case you can match the share transfers for the buy and the sell in three days time. The alternative but more complicated way, is to vary the settlement period. To explain this we have to go back to the house example - just as people purchasing a home may ask for some additional time because they have not yet sold their current property (and as of yet do not have enough money to buy the new home), likewise you may be able to negotiate an extended settlement period for a short sale of stock, which will give you additional time in which to buy it back. If all of that sounds a bit hard and fraught with danger, it is.

 ...Continues here - Borrowing and Lending Shares for Short Selling