A naked short is when you sell a stock without owning it or having borrowed it first. Naked shorting stocks is supposed to be illegal in the US.
But what is shorting a stock?
Normally, if done legally, one shorts a stock by finding someone who owns, the stock, borrowing it from them (at an interest rate) selling it into the market, then if the stock goes down, one can buy it back and return the stock to the lender. In doing this the number of shares outstanding remains the same.
A naked short is when one sells a stock without first owning it or borrowing it from someone else. The the rest of the process is the same, expect one closes it out by buying the stock back.
So let’s look at a basic example I’m using simple and small numbers to highlight the concept but, if you increase the number of traders and prices and shares, the concept still applies.
Scenario A Example: Short
Acme Co. stock is trading at $1 per share and there are only 100 shares in existence. Person A owns 10 shares of Acme Co. Other people own the remaining 90 shares. They loan the 10 shares to person B so Person A now has 0 shares of Acme Co., person B pays person A interest for the duration they are borrowing the stock, and person B sells that stock into the market at a price of $1 per share to Person C. So they pocket $10 less the interest they paid. There are still 100 share in existence, 10 of which are held by Person C.
Now let’s say the price of Acme Co. stock drops to $0.90. Person B (the short seller) then buys 10 shares of Acme Co. from some other shareholder who is willing to sell for $9 in total. They give those shares back to person A to close their short. And they have just profited $1 less any interest paid.
Source: https://www.investopedia.com/terms/n/nakedshorting.asp
Is Shorting Ethical?
Now some people don’t like that people can short stock because it is “betting against a company.” Now there are plenty of things I don’t care for but I don’t want to be illegal. I don’t like most of the “popular” music produced today. But I think people should be free to produce music even if I don’t like the result.
I think if I own stock, I should have the right to loan it to others to collect interest. I also think that people have the right to borrow stock from a willing lender. And if someone has borrowed stock, they should be able to sell it (provided both parties agree that the borrowed stock could be sold, and provided the shares are paid back). Since I believe in those two things it follows that people can choose to short stock.
It’s also interesting that people don’t seem to have a problem with borrowing a stock in the hopes that it goes up. Some people essentially borrow stock (using margin accounts) in the hopes that it goes up in value and they can sell it at a profit. You can’t allow people to bet on a stock going up if there isn’t someone taking the other side of the trade essentially betting it will go down.
Now, what I do think should not be allowed (because I believe it is fraud, very much akin to fractional reserve banking), is naked shorting of stock. A naked short is when you sell stock that you don’t own and didn’t borrow from someone else. This essentially introduces new shares of the stock into the financial system that never existed. A company has the right to issue stock, but a random person doesn’t have the right to issue stock in a company they don’t own or control.
So let’s look at our other example only this time it is a naked short. Again, this is illegal in the US in Europe. But it does happen through various loopholes I don’t pretend to fully understand.
Scenario B Example: Naked Short
Acme Co. stock is trading at $1 per share and there are only 100 shares in existence. Various people own the 100 shares. Person B’s broker allows person B to sell 10 shares of Acme Co. stock in exchange for a fee and/or interest. The broker does not own any shares of Acme Co.. Person B sells that stock into the market at a price of $1 per share to Person C. So they pocket $10 less the interest they paid. There are now 110 share in existence, 10 of which are held by Person C.
Now let’s say the price of Acme Co. stock drops to $0.90. Person B (the short seller) then buys 10 shares of Acme Co from some other shareholder who is willing to sell for $9 in total. By buying 10 shares, this closes out their short position. And Person B has just profited $1 less any interest paid and/or fee.
So that is my understanding of you could short a stock beyond the number of shares issues by the company, through naked shorting.
Now the actual mechanics of stock trading behind the scenes is more complex. Trades don’t settle on the same day. Once a trade is closed, it still takes a few days before the trade is settled. Brokers allow buying and selling and they don’t true up their books until later. I don’t pretend to understand all these mechanics.
Scenario C: Short Squeeze
So let’s look at scenario B, only the price of Acme Co. goes up.
The first part is the same:
Acme Co stock is trading at $1 per share and there are only 100 shares in existence. Various people own the 100 shares. Person B’s broker allows person B to sell 10 shares of Acme Co. stock in exchange for a fee and/or interest. The broker does not own any shares of Acme Co.. Person B sells that stock into the market at a price of $1 per share to Person C. So they pocket $10 less the interest they paid. There are now 110 share in existence, 10 of which are held by Person C.
But now: let’s say the price of Acme Co. stock rises to $1.10. Person B (the short seller) then buys 10 shares of Acme Co from some other shareholder who is willing to sell for $11 in total. By buying 10 shares, this closing out their short position. And Person B has just LOST $1 less any interest paid and/or fee. Now $1 isn’t a big deal and Person B in case case can come up with the money to pay it. But on a large scale this can be a big problem.
If the price of Acme Co. had risen rapidly to say $20. Short Seller Person B would need to come up with $10 to close out their short position. If instead of being short $10 worth of stock, perhaps they were short hundreds of thousands of shares and the losses are now in the millions. There is also a problem of liquidity. Maybe no one wants to sell their stock in Acme Co., they are happy to hold it and see if it goes higher. Maybe more buyers come in and are willing to buy in at $20, driving the price up even further. Person B might get into trouble because they might not be enough shares available to buy back and close their short position.
Brokers will often hike margin requirements when markets move quickly in one direction or another to protect themselves. The broker in scenario C where Acme Co. went to $20 might have said to the Short Seller Person B, “you have to deposit another $10 into your account or we will liquidate your position at the current market price.”