What is Naked Short Selling? - Stock Market Investing Article

By:Joel Arberman

Naked short selling or naked shorting is an illegal stock trading practice, in which investors sell a particular stock which they do not possess and can not borrow. In capital markets, this practice is called Fail to Deliver (FTD), since the seller fails to deliver the shares to the buyer. In ordinary short selling, an investor borrows shares, which he believes overvalued, and then sells in open market. If you do so, you may make profits by buying the same shares once the share price declines after sometime. Normally, overvalued stocks fall and recover after some time. In a naked short selling, the sellers do not borrow stocks and do not intend to borrow the shares to make the delivery within the required three-days time period. The sellers fail to deliver the particular stock which they are supposed to deliver, resulting in ‘failure to deliver.’ It is widely believed that some professional investors and hedge funds are involved in naked short selling by using loop holes in the stock trading system.

How does Naked Short Selling work?

In a naked short selling, the sale is processed without the possession of the stock by the seller. Although naked short selling is illegal, it is legal under certain circumstances. For example, if you are a market maker who needs to provide shares for a stock which has limited liquidity, naked short selling becomes legal. This ‘fail to deliver’ system can create widespread deterioration in micro-cap stocks. The investors with short positions may pick on small emerging companies and cause their stocks to plummet. This would also induce investors with long positions in micro-cap stocks to abandon their positions. However, some on Wall Street believe that naked short selling is promoted by the owners of small public companies in order to divert investor attention from corporate issues and regulatory problems surrounding them.

Naked short selling may have a negative effect on the entire stock market, since the fraudulent investors can use naked short selling as an instrument to manipulate the market. Many of these illegal trades go unpunished, since only those investment companies, which are the members of the NASD are required to comply with delivery rules.

North American Securities Administrators Association (NASAA) recently commented that there has been no substantial evidence that naked short selling exists. NASAA was established to monitor the functioning of Reg SHO, a regulatory body established to modernize naked short selling rules. The Depository Trust & Clearing Corporation (DTCC), which provides clearance, settlement and information services for equities, corporate and municipal bonds, government and mortgage-backed securities, money market instruments and over-the-counter (OTC) derivatives transactions, said recently that 9 of the 12 cases filed against it by the plaintiffs are either dismissed or withdrawn. DTCC, however, did not deny the existence of naked short selling.

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Joel Arberman is the Managing Member of Stock Aware, LLC. We publish a free investment research and analysis newsletter. Learn more at
www.StockAware.com

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