No More Naked Shorts!

Posted: August 12, 2009 in Business & Economics, Main Articles & Blog News

Last week, the Securities and Exchange Commission (SEC) made permanent its ban on Naked Short-Selling, or “Naked Shorts”… for short. Now that just sounds plain wrong and lowdown dirty, to those of you unfamiliar.  But to those of us who follow the Street, here’s the DL: In the lore of stock-market trading, a short sale of a publicly-owned security (i.e., stocks) entails borrowing stock instead of buying it, with the hope that its price drops within trading deadline or parameters. When the price drops as expected, then the short-seller “cashes” in the stock but winds up getting a windfall, since it is now the entity borrowed from who has to pay up (usually, it’s the broker’s firm).

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Why short-sell? There are two main reasons, both perfectly valid.  The firt is if there is an impression that a company’s stock is overvalued, i.e., its price had been inflated but it little or nothing to justify or show for it; this is known as speculation.   George Soros pulled off the most famous (and I will add, legitimate) of such a stunt, when he short-sold the British sterling currency back in 1992, the infamous “Black Wednesday” incident.

The second main reason is when investors want to protect their interests by hedging, or offsetting their main position.  This is commonly done by commodities investors and producers of commodities themselves.  For instance, a farmer may expect his wheat produce to increase in price by the time it is sold; but in the event that demand for wheat decreases (causing the price to go down), he can offset the adversity by selling wheat futures contracts short, that is, borrowing against them through a trader. While the actual mechanics may be a bit much to include here, the bottom line is that the farmer will walk away with some profit, in either case. It doesn’t matter to such an investor that he or she may miss out on a bigger payoff, as getting any kind of profit is better than none.

In naked short selling, the same procedures for short-selling apply, with one big difference:  The speculator does NOT borrow the stock, which means there is no assumption of risk at all. In short (tired of this word yet?), it amounts to nothing more than a promise to sell the stock short, instead of the actually selling it short altogether. If not exercised (in other words, if the naked short sale doesn’t become an actual short sale), a “fail to deliver” notice materializes. There are two consequences that may result: First, the naked short seller won’t get anything, except any interest that applies. The more serious concern is that the price of the stock gets driven down more than it ought to be; when a company is shown to have 125% of outstanding and owned stock — that’s a big problem. That means that people have been driving down stock without owning up to it. The presence of naked shorts abuses, you could describe as a legion of parasites taking something for free, instead of paying for it in some small way. As of last week, that practice was officially prohibited by the SEC and all the powers that be, in an effort to reduce the rampant speculation that has accounted for a portion of the market’s decline, as well as the demise of such financial giants like Lehman Brothers.

Traders

Even without strict enforcement, the new rule would make freewheelers think twice before making wild speculations. But what about long-term effects? There is an implicitly negative view of short-sellers. However, it cannot be denied that they make the markets more honest, more accountable. They help make the market efficient.  Without short-sellers, the losses from the previous financial crisis may have been ten times greater.  More to that, the increased presence of short-selling should be a symptom that something is wrong with the market – nay, the economy!

While banning naked shorts is great as far as the issue of badly need controls, there is still the bigger picture to be considered. So what is the SEC, the Fed, or the Treasury doing to prevent larger entities – such as banks and other financial institutions – from taking riskier ventures like Credit Default Swaps, that turn toxic and cost nearly trillions in public money? Regulators are good in figuring out small-time grifters; now they must figure out a way to make the banks more honest and less prone to exercising wasteful risk.  It would be the next big step in regaining the public’s confidence.

Given the trauma in the form of recession, that might be a while.  Meanwhile, don’t get caught wearing naked shorts. You might be cited for indecency.

For your information and amusement, here are more articles:

US Rules on Abusive Short Selling

Naked Short Selling

Mechanics of Short Selling, Naked Short Selling & Synthetic Short Selling

Eat My Shorts – Short Selling in Australia

P.S. I definitely have nothing to do with any random ads or articles here that show “Mad Money” host Jim “Blabbermouth” Cramer. Go watch Suze Orman and learn a thing or two about saving money instead!

Copyright Anabasius 2009

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Comments
  1. While I agree with the basics in The Anabases | No More Naked Shorts! , I think the buoyant sentiment around at the moment is a result of a politically engineered set of circumstances. The demand for consumer loans is still weak and there is no improvement in the housing market. The developed countries are surviving on their governments ability to just borrow and spend into their economies which is difficult to maintain. Regards, Mirella Kahan.

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