What is Naked Short Selling and What Does It Mean To the Market?

The government has “temporarily” banned the trading practice of betting against financial stocks, but only on some stocks. The reason is supposedly to try to boost investor confidence.

Now, there are a few questions to come to mind: What is Naked Short Selling?, Why is everyone saying its so terrible?, and Is it really as bad as they say?

Now, firstly:

What is Naked Short Selling?

Let’s go over what regular short selling is. Selling a stock short is taking a negative position on a stock, it’s essentially a bet that the stock price will go down. To do this, a person has to first borrow shares from a brokerage house or a bank, sell those, and then buy shares of the stock back at a later date to repay the borrow, hopefully when the price has gone down. It’s common practice on Wall Street, and is really just a form of credit given by the brokerage house or bank.

Naked short selling is selling a stock short without first borrowing the shares. If a stock is illiquid (no shares readily available), and a trader wishes to speculate on an anticipated hourly move in the share price, nothing is harmed by allowing him to sell 1,000 shares and then buy them back 45 minutes later. That, too, is common practice on Wall Street. Naked short selling helps the market prices adjust quickly.

Why Is Everyone Saying It’s So Terrible

This really is a deep question that has more to do with human psychology than it does with the market. Some bad things are happening in the market right now. When bad things happen, there needs to be an explanation, there needs to be someone to blame.

Finding someone to blame, whether it’s right or wrong, gives the person doing the blaming power; political and financial power. It makes it appear that they understand the situation and have it under control.

And really, short sellers are easy to blame. They’re betting the market will go down. We naturally hate those negative bastards right? They shouldn’t be hoping the market will go down (even though that’s not what they’re doing, they’re only trying to make money based on what they think will happen, just like anyone else in the market). There’s actually a Latin term for it: Cui Bono. It essentially means, “when something bad happens, see who benefits from it, and blame him”. But short sellers are not to blame for the financial crisis any more than long sellers are to blame for the success of a company like Apple or Google.

Is It Really As Bad As They Say?

No, it isn’t.
People are concerned with price manipulation. The fear is that a rogue trader could spread false rumors about a company while massively shorting its stock. Such aggressive actions would supposedly push the price down, and allow the trader to make loads of money from his devious plan.

The fact is, though, that sort of thing doesn’t happen, and can’t. For one thing, why couldn’t large stakeholders do the same thing with long positions? Steve Jobs could spread rumors about Apple and begin unloading his huge position. After the price fell 50 percent, he could buy back his original position, having netted perhaps hundreds of millions of dollars in the process, and owning the same number of shares as before. Steve Job’s actions wouldn’t have changed the underlying profitability of Apple, and so its artificially depressed share price would presumably recover over time. No government regulations on short selling could stop this type of maneuver.

The market isn’t stupid. It takes manipulative schemes into account. For example, if the stock price of a well run company is going down because of a devious person shorting massive amounts, then informed investors will buy it up, since it’s then trading at a discount. This would offset the effect of the shorting.

The main point is that no one forces investors to listen to rumors, and good investors never will. Government regulations can’t protect people from their own gullibility. In fact, attempts to do so perversely give them a false sense of security, and make things much worse.

Conclusion

Really, the ban on short sales is pointless. All it does is prohibit naked short sales on nineteen “important” financial companies. In other words, even if a trader intends to short shares in one of the companies and to buy them back within an hour, the brokerage must first locate and borrow the shares before allowing the sale. The restriction apparently does nothing except require more paperwork and reduce the attractiveness of short selling. (Because of the extra delay, share prices might move before traders can short sell them.)

Short selling is a beneficial process that allows anyone to participate in the market’s price setting. So long as contracts are enforced, even naked short selling is helpful, since it allows the quickest possible adjustment in mispriced stocks. The government’s recent efforts to “protect” nineteen favored firms from naked shorting will do nothing but raise transaction costs.

Remember this: Banning short-selling is the financial market equivalent of making it illegal to argue on one side of a debate. It promotes a disconnect between price and value, which is what got us into this mess in the first place.