Short Selling

What is Naked Short Selling?

Naked short selling is an illegal trading activity that occurs when a stock is sold short on the market without ever borrowing any shares.  In a normal trading transaction, the broker will provide the required shares in real-time or acquire them shortly thereafter to ensure there are shares on hand for the short position.  The end result of naked shorting is the price of the security is pushed lower by "fictitious" shares being sold on the open market.  This type of manipulation leads to bear raids that pushes prices to extremes and creates volatile moves in the market.

Tracking Naked Short Selling

Tracking naked short selling can be extremely difficult.  Since the short position is never opened, there is no buyback to close the position.  So, the trade is categorized as "having failed" to deliver and there is virtually no way of knowing who initiated the naked short.  This allows an unlimited number of sales orders to flood the market thus disrupting the normal supply and demand balance for the security. 

Naked shorting would not be possible without brokerage firms who allow the shorting of stocks that are not on the easy to borrow list, which leads to short sales for which the broker can not support.  As a result of the 2008 credit crisis the SEC finally admitted that naked shorting is a problem.  The SEC has now begun to place even further limits on short selling by amending the Regulation SHO rules to require short sellers to deliver securities a minium of three days later.  Many politicians are now pushing to have broker dealers be required to deliver the borrowed security on the actual settlement date.

What is Short Covering

Short covering is the act of buying back shares in order to close out a short position.  Short covering is often a tough concept for novice traders to grasp, because it is the exact opposite of going long in the market.  The majority of retail investors understand that if they buy a stock the only way to close out the position is to sell.  With the horrendous drop in the world markets as a result of the 2008 credit crisis, many novice investors are wondering how they could have profited from such destruction.  The answer to this question is shorting the market.

Example of Short Covering

Let's assume a trader was short Citigroup at $23.50 in early October.  In order to open this position the trader would sell short 500 shares by borrowing these from their broker and selling them on open market.  This creates a net short position for the trader.  So, the only way to close out this position is to buy back or cover the position.  In the below chart Citigroup experienced a free fall down to $3.  This lead to a massive short squeeze which shot the stock up over $8 in a matter of days.

Short Covering and the Market

Many investors believe that shorting is evil.  However, shorting is a normal part of the markets and adds to its liquidity.  For example, as a stock begins to fall precipitously, many traders that are short will begin to cover their position to get out with a profit.  This short covering sends a large number of buy orders into the market which in turn creates counter move rallies.  Without short covering, the market will just continue to float lower, as buyers are not willing to step in front of a falling knife.

John Tabacco discusses the concept of short selling.  It represents 35% of all transactions in the market.  He discusses a few stocks that he recommends as short selling candidates.