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Friday, February 18, 2011

What is naked short selling?

Naked short selling can mean one of two things depending on the interpretation of the language. It can either mean selling shares short that don't actually exist or writing a naked call option that is exercised. This is financial semantics because each are similar in meaning and can be called 'naked short selling' except the latter is legal naked short selling whereas the former is illegal naked short selling.

The word naked is key here because in one sense it means 'uncovered' or 'uninsured' and in the other it means non-existent. To understand what naked short selling is, it helps to first understand what short selling is, and then to see short selling in the event of naked short selling. The following illustration with Comex cat and laugh track illustrates th concept.

Short selling

Shares or company stock are sold short when the shares that are sold are done via a 'stock option' which is essentially a credit agreement between the seller and the broker in which the seller sells stocks that may later be bought from the broker or option writer. If the option is not exercised however, the buyer of the put option who purchased the right to sell loses the option fee paid for the right to sell.

Naked short selling via uncovered call options

Naked short selling via uncovered call options involves writing an uncovered call option that is exercised by the option buyer. What this actually means is an investor, trader or broker decides they are going to bet on the price of a stock going down in value. They make the bet by writing a call option which means the buyer of the call option buys from the seller. However, if the underlying stock rises in price, the writer of the call option must still sell at the lower price leading to a potential loss for the seller. Since selling short is betting on a price decline, this is also naked short selling.

• Example of naked calls

In light of this, the writer of the call option has to buy at the market price of the stock when the call option is exercised by the buyer. For example, Mr. Jones writes 1 call option for ABC company with a strike price of $10.00. This means Mr. Jones must sell 100 shares of ABC company at $10.00 when the buyer of the call option decides to exercise his or her write to buy the 100 shares. If the shares fall below $10.00, to $7.00, and the option is not exercised Mr. Jones simply does not exercise his right to sell the option and recovers the cost of writing for the buyer.

Naked short selling via non-ownership

Illegal naked short selling is short selling stocks that don't exist. For example, Mr. Jones decides to buy 1000 put options on margin from a broker. The broker is assumed to have access to the underlying shares and purchase them for the option within a specified period of time. If this does not occur the shares have been sold naked because they haven't been proven to exist in the records of the brokerage company.

• Example of naked short selling via non-ownership

An example of naked short selling via non-ownership would be when Mr. Jones decides to buy 100 put options for which the broker through which the transaction is facilitated has not purchased underlying shares.

To illustrate further, Mr. Jones' 10 put options have a strike price of $10.00 which means he is buying the right to sell 10 options at a price of $10.00 should he so choose. If the price falls below$10.00 to $9.00 he makes $1.00 per share minus commission and/or premium. The only problem is the shares which he's selling where never actually owned by the broker or the option writer. This is the illegal or naked short selling because there theoretically was nothing to sold.

The reason naked short selling can mean two things is embedded in the terminology of options investing. Writing a naked call option means selling the right of option to buy shares to an option buyer. Naked short selling via non-ownership means shares sold short either via put options or naked call writing are unowned.

In the former case, it is both naked and short because the option writer is betting on the option's price going down so (s)he can keep the premium and also have not insured him or herself by owning the shares in case they rise in price, hence making them naked.

If the buyer of put options is buying the right to sell shares at a certain price from either an option writer or a broker, but the shares are never actually bought by the broker in regulated time allowed, then this is naked short selling that is illegal. It is illegal because 1) it can lead to market manipulation if the brokerage allows excess short selling without underlying shares and 2) because the broker never completes a transaction which is fraudulent fabrication of ownership.


1) http://www.investopedia.com "Investopedia": Short selling, naked call, naked short selling