Finance

What is Naked Short Selling and What is its Risk?

What is Naked Short Selling and What is its Risk?

What is Short Selling?

Short selling is a trading strategy generally done when an investor expects the price of the stock will decline. The investor believes the price of the stock is overvalued hence, they would sell. Short selling can be used for speculative purposes as well as for hedging purpose from a long position taken.

The investor borrows a security today, he expects a decline in the coming period. So, he sells the security to another investor. When the price declines he borrows the security and returns to the lender. The difference in the price he sold and the price he bought today is his profit/loss.

For example:

  • Investor A borrows securities from investor B for $100 today. He expects a decline in price in the next 3months. He sells the borrowed securities to investor C today at $100. After 3months, the price of the stock is $75. He purchases a security from the market at $75 and returns it to the borrower (investor B).
  • Thereby, making a profit of ($100 – $75) $25 per share (commission, brokerage, and taxes are ignored).
  • However, instead of a decline in price if the price would have been increased to $115 then, in the case the investor will purchase a security from the market at $115 and will give it back to the borrower. Consequently, making a loss of ($100 – $115) $15 per share.

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What is Naked Short Selling?

  • Naked short selling is also known as naked shorting is a strategy in which an investor sells the share without first borrowing it or by ensuring the shares will be borrowed in due time.
  • Even in this scenario, an investor expects the share price to fall but there is no lender to allow him to borrow security or the cost of lending is too high.
  • If an investor delivers securities and gives it back to the borrower he can make a profit/ loss. If an investor fails to deliver within a given time frame, then it is known as “failure to deliver”. Trades fail because the covers are not easily available.

For example, Investor A expects a decline in price in 3months. So, he tries to borrow security but it is not available. So he sells shares to Investor C without actually holding it. If he manages to borrow and sells to Investor C then, the trade is complete. If he fails to borrow then it is known as “failure to deliver”.

Detailed Example for Naked Short Selling:

  • John, an investor decides to enter into a contract with Ajay to short 500 reliance shares each at a price of Rs. 1000 per share and decide to adopt a naked short selling technique.
  • The date of settlement that is the delivery date of those 500 shares is fixed 5 days later after the contract was made with 3 days of additional trade settlement period that is after 8 days of the contract made.
  • Now in order to make a profit , he needs to purchase those share at a price which is less than Rs. 1000. If he fails to deliver those shares within the specified shares, he would be liable for penalties.
  • Suppose on the 5th day, the price rises and goes up to Rs. 1050, thus he would have no option left and would be liable to purchase the shares at Rs. 1050 per share and deliver it to the authorized party within the ate specified.

The Dark side of Naked Short Selling

  • Naked short selling can be used by investors to manipulate the market. It tends to drive down the value of the price of a stock. As “A Los Angeles Times editorial in July 2008 said that naked short selling “enables speculators to drive down a company’s stock by offering an overwhelming number of shares for sale”.
  • It is also believed naked shorting is promoted by small companies to create a diversion from the issue the company is facing.

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Regulations of Naked Short Selling

  • SEC asked Regulation SHO (it governs short sell strategies to prevent unethical practices) to focus on abusive naked short selling to reduce failure to deliver.
  • After 2008, the Securities and Exchange Commission (SEC) in the US has banned the practice of naked short selling after the financial crisis in 2008. Many countries outside the US have also banned naked short selling.

Risk and Advantages:

  • Naked short selling is an illegal practice and is termed abusive by SEC in 2008 because purposeful shorting of the huge volume of a stock in order to bring down the prices.
  • It also allows people to manipulate stock prices without taking into account supply and demand. Despite being made illegal after the 2008 – 09 financial crisis, naked short selling continue to happen because of loopholes in the rules and regulations.
  • Naked short selling is a very risky as well as high yielding technique. It aims to buy back the security at a lower price than what it was for thus making a gain on the difference.
  • The main danger behind this technique is that if you fail to deliver the said securities on scheduled and specified time, there are penalties. It is also a very big problem in the management of the stock market.
  • The advantage lies in terms of naked short selling is that one does not have to pay interest on the borrowed shares for as long as you can short sell even if one is not willing to lend the shares. It also provides an opportunity to speculate and attain higher yields.

Author: Swati Krishnamurthy

About the Author: Swati is a freelance writer. She is a Financial Quality Compliance specialist having integrated knowledge and experience in Logistics, Audit, and Risk-mitigation for manufacturing and service sectors. Her passion for finance grew as she scored centum in financial management during her master’s degree. She’s a classical dancer who performs to express complex emotions through her dancing and writes to express complex concepts into simple words.

 

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