As we have learned, selling a stock short is taking a negative position on a stock, it’s essentially a bet that the stock price will go down. You have to first borrow shares from a brokerage house, sell those, and then buy shares of the stock back at a later date to repay the borrowed ones, hopefully when the price has gone down.
Naked short selling is a practice of sale that is conducted before the seller has proper ownership or has been authorized to sell the security by the current owner. Naked short selling is conducted with the anticipation of being able to buy back the security at a lower price in short order, thus covering the original sale and managing to make a profit from the venture.
While the strategy of selling a stock short is considered ethical and legal in many parts of the world, naked short selling is considered to be highly unethical in most markets.
The SEC declared general naked shorting illegal in 1934. but they included a provision allowing market makers to employ the use of naked short selling when the anticipated result was to increase the liquidity of the investment market and help to restore some balance to an unstable situation.
Naked shorting to drive down share prices violates US law. Many companies have been accused of using naked shorts in order to make profits at the expense of share prices. To do this, the trader simply enters a naked short with no intention of ever delivering the shares. A large enough short sale could cause the price to fall, as is the case with any stock being sold, so as long as the trade is large enough to move the share price, the short is likely to be profitable. Normally this would be risky; if the price did move back up for other reasons, the trader would be driving the price up with every purchase, a condition known as a "short squeeze". But as long as the buyer turns around and shorts it back into the market, the price continues dropping, making the trades profitable even though no one actually holds any of the shares.
IS IT REALLY AS BAD AS THAY SAY?
You will hear from some people that naked short selling is not bad for a stock market. But it is. If you allow someone to sell stocks he doesn't own, if he does it in 1000 shares it’s not a problem. But what happens if he short a 100,000,000 shares of a company? The result is that naked short selling creates an increased supply of shares of a company and price of the stock eventually falls. So the fear is that, even if there is no reason for stock to fall, and the company is in great business like Coca-Cola Inc. someone could drive prices down and profit from it or by buying put options.
To help you understand this, I’ll give you an example: let’s say you bought a house for you your family for $100,000. You agreed to put a deposit of 30% ie $30,000. You pay your mortgage, and everything seams fine, until one day you realize that someone naked sold short your mortgages and several other in that area, increasing supply of houses like yours, and driving the prices down fast! As a result, the price of your house fall below $30.000 and you get a call from your bank (ie. a margin call) requesting to pay the difference or they will sell the house at the market. Next day, your house is sold a you had to move out. A week later, price of the house goes back up to $100.000.
That’s how feels every investor or Bear Stearns, or any other company which was under heavy naked short selling in the period of crash in 2008. Yes, prices fell anyway, but the question is did someone manipulated and fueled that fall?
CONCLUSION
Don't get me wrong, short selling has an important role in price discovery process, because short sellers are reality check and they try to exploit inefficiencies and short sell companies that shouldn't have high valuations. That is OK. But allowing someone to sell something he doesn't own, in a way that each of his sale further depress and manipulate the price should be and is illegal.
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