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I got the impression from the news that: 1. Some countries including the US banned all short selling (naked or not) in some shares. 2. Naked short selling is apparently always of dubious legality, and the SEC was making inquiries as to whether some organizations had done this, and perhaps done it in a manipulative way.

The key point that isn’t explained very well is that Sam can naked short sell a million shares, and if after three days he still fails to deliver, he incurs no penalty. Caitlin is unhappy but has no recourse. So Sam can manipulate the stock price downward by selling a lot of shares that don’t exist, until he kills the company, and after the stock goes to zero he has no problems covering his shorts.

Short selling manipulates the Market. The stock is trading at $10. You say to people, “I’ll sell you a million shares at $9 and deliver in X days. Pay me now.” People won’t pay $10 or more now because they know you’re offering at $9, even if they don’t take you up on the offer. It pushes the stock down. Naked short selling just lets you do it without any investment, which is dangerous as hell to other investors. I think all short selling should be illegal.

Interesting video.

In the naked short selling case, it didn’t really explain why Sean wouldn’t sell Sam the shares for $5. It would seem that in a market like ours someone would sell Sam the shares $5. Why would they not?

Maybe because Sean believes $5 is artificially low because of all the short selling?

Imagine how different the US economy would be if you were REQUIRED to hold a stock for at least 10 days after its purchase. Right now, there is so much happening so quickly, both up and down, that no one knows what “level” might be.

Hi Bryan You’re right, the US initially banned naked shorting, and followed up, along with the UK, with a ban on all short selling for a time. The US lifted that ban early this month. But neither shorting or naked shorting are illegal. In fact, naked shorting has a long history. What’s illegal is manipulating the market to profit from short selling. Just as manipulating the market to gain from upward movements in shares is illegal.

Hi A Chen You’re right, there is no penalty incurred by Sam if he doesn’t get those shares to Caitlin (unless the parties draw up a contract that specifies a penalty, which I believe does happen in some cases). But what if Sam doesn’t pay up? Caitlin will sue for breach of contract, if only to get her money back, and Sam’s reputation would be badly damaged, if not irreparably.

Could someone please explain (in clear, concise terms) the reasoning behind short selling and the other complicated vehicles by which our economy is being run? Why does the monetary industry have to be so complicated? Is it to keep ordinary folks confused while less-than-honest manipulators skeedaddle with our investments?

i wasnt going to comment but i couldnt help it. First of all why do they call “naked” it should be known that shorting a stock you will be “naked” if not you would just be selling your own stock. Second why is this such a big deal? short selling is just the other part of the equation, if people think it “overvalued” they will short it. the argument that “people should’nt be able to sell it if they dont own it” should be the same argument as “you shoulndt be able to buy a stock, if you dont have all the money” but you can with only 50% of the price using a margin account. why didnt we argue this point in the internet bubble, that people were inflating the price using margin accounts? i guess this is the reason you cant really say buying stocks is a zero sum game, due to the margin(inflation) and shorting (deflation). unlike futures and options, besides if you knew that the price would drop, you shouldnt short it, sell calls and buy puts, you get much more leverage doing this than shorting a stock by far.

Whilst in some ways this simply gives me more questions, I just wanted to say thanks for the clear, well explained vid!

Thx for the informative vid. Nice to understand a bit better how it works :)

Your explanation forgets to say the Naked Short Selling breaches SEC ACT of 1934 sec 17A and it is stealing allowed under SEC REG SHO loop hole. See www.deepcapture.com for a real explanation of the problem. REFCO was caused by this and it starts by allowing non regulated entities (today controlling 2 Trillion in capital) to breach the system. SEC the US Treasury and President Bush need to take responsibility and allow transparency on all short selling just like we have with long purchases everyday. The system has allowed the selling of insurance (CDS and PUTS) on assets that are then destroyed in terms of GAAP Book Value. SEC and CBOE have been aware of this for many years and their failure since compliance date has assisted this crisis.

As usual the problem is with enforcement of existing rules. John’s broker should NOT take the order unless he has some evidence that John can deliver the shares at settlement (either borrowed or long). That is why short sellers who work with reputable brokers (yes, there are a few) first get a “locate” which is a comfort statement from the lender that he/she can get the shares. For instance, it is almost impossible to short Sears since no broker can lend any shares.

In addition, if Caitlin, for whatever reason, doesn’t receive her shares in 3 days, her broker can issue a “buy in” which means the broker can, after notifying John’s broker, buy the shares in the market AT MARKET PRICE and bill John’s broker for the difference with the original trade (if any).

Economically, short sellers neither add nor subtract ANY shares to/from the market. In essence, John is just an intermediary between Caitlin and Sean.

btw, the US market is NOTORIOUS around the world for lax enforcement of settlement rules. In many foreign exchanges, the authorities themselves automatically execute the buy-in after 2 days and the selling broker is responsible for his client.