Naked Short Selling

Discussion from AD 717 Investment Analysis and Portfolio Management at Boston University

Naked short selling is when a trader sells shares that have not yet been borrowed. When naked short selling occurs, stock that is not on any books is being sold. Theoretically, a company can place unlimited orders to drive down a company’s stock price, and since no stock is being traded, the strategy can be used to manipulate the market. Naked short sellers can gimmick and take advantage of the time it takes to clear each delivery of a stock order.

In 2010, when describing scandals and conspiracy of banks on live TV, Max Keiser provided what I believe the best and most rudimentary way to describe naked short selling: you charge $1M to your Visa card, Visa goes out of business, and you get to keep everything (1). The concept of naked short selling is similar – a trader gets to keep the cash after making a sale of a trade that they do not own, and if the company goes bankrupt prior to the clearing of the trade, the trader keeps the earnings. The most notorious example of naked short selling – and to the best of my knowledge the last to make major news – is Lehman Brothers. When Lehman crashed, as many as 32.8 million shares in the company were sold but not delivered to buyers on time (2).

While I agree that naked short selling should not be allowed (or should have extreme regulations), I believe that short selling (not naked short selling) is very efficient and beneficial for markets. Short selling, which first requires a trader to borrow shares before they sell, assists in keeping market balance. Short sellers subtract their initial buy price from the ending price, keeping the profits, or having to pay up if the ending price rises. This keeps a balance; if there were no short selling there would always be an unbalanced upward bias.


(1) http://www.youtube.com/watch?v=2-PihbVN6O4
(2) http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aB1jlqmFOTCA