Naked short selling, or naked shorting, is the practice of short-selling a tradable asset of any kind without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale. When the seller does not obtain the shares within the required time frame, the result is known as a “failure to deliver”. The transaction generally remains open until the shares are acquired by the seller, or the seller’s broker settles the trade.
Short selling is used to anticipate a price fall, but exposes the seller to the risk of a price rise.
Naked shorting is not illegal, though it is now against SEC regulations. For many years it occurred frequently, for the most part without any sinister intent. If traders wanted to short an issue, they placed an order with their brokers. The brokers would usually fill the order immediately, even if they hadn’t yet managed to locate stock to borrow. The short sale went through, and stock was located and borrowed within the next few days. No real harm was done in nearly every case. Still, the process was sloppy. Stock that should have been delivered within three days often wasn’t delivered for five or six days.
Although a Federal appellate panel had upheld the legality of naked shorting, in 2004 the SEC decided it was time to do something about what was perceived, rightly or wrongly, as a growing problem. Regulation SHO, implemented in January 2005, introduced locate and close-out procedures designed to ensure that shorted stock was actually borrowed, and that delivery actually occurred. With Reg SHO came the Reg SHO Threshold List, which flags issues in which significant failures to deliver have occurred. The SEC cautions that not all fails to deliver are caused by naked shorting; they can be long as well as short, or caused by other issues. Any stock that lands on the SHO list will stay there until the threshold fails are cured.
Reg SHO appears to be working well. Once the list was relatively long; now it’s quite short most days. It’s publishedevery night at around 11 p.m.
The FINRA daily short volume report
In February 2010, FINRA began publishing a daily report showing short volume in all issues traded that day. They did so under pressure from the SEC, who told them “transparency”—evidently even of the meaningless kind—was required. In November 2009, Jess Haberman, a FINRA official, expressed concerns about the soon-to-be published list, noting that:
…with respect to broker-dealer proprietary sales, especially when acting in the capacity of market makers and block positioners, such trade volume information may not always depict accurately the quantity of stock sold short. It may tend to over-count such volume, and therefore, if published, unnecessarily impact investor confidence in an unforeseen way.
Haberman was correct. The Get Shorty bunch jumped on it with glee, proclaiming that it “proved” naked shorting in every penny stock out there. Worse yet, they added up the numbers from day to day, which resulted in gigantic and ever-increasing short positions for just about every penny stock. Short numbers of any kind are never added up: they are a running balance. Each day, some shorts are covered; others are opened. It’s like your checkbook.
Essentially, the short volume reports reflect MM activity. They report nearly all trades, and only the first leg of any trade is printed. As Haberman pointed out, the MM reporting a short sale may cover immediately, and end the session flat. Anyone who calls FINRA to ask about all this will be told to rely on the bi-monthly short interest report, also published by them.
In the three years since the daily short volume report first appeared, not a single short squeeze could have been predicted based on the information contained therein. Yet the NSS fanatics continue to beat the drum.
Nonetheless, websites like buyins.net, run by Tom Ronk, and otcshortreports.com, run by John Lux, claim to be able to call a squeeze based on the daily short volume numbers. So far, they haven’t been successful in doing so, though many readers mistake strong rallies for squeezes. Buyins.net is a promotional site; companies pay Ronk to produce “squeeze trigger reports.”
Traders do short stocks, and market makers qualify for an exemption that allows them to short stocks naked in order to provide liquidity. The latter must always trade against market sentiment: if retail wants to buy, they must sell; if retail wants to sell, they must buy. If the MM miscalculates, and finds himself with a serious imbalance he can’t cover going forward, he’ll be in serious trouble. Traders too will have difficulty covering if the stock rises precipitously. Both will be susceptible to buy-in notices from their clearing firms, and could lose very significant amounts of money as the stock rockets higher and higher. That is a short squeeze, and for longs, a squeeze is a delightful experience.
Most short squeezes occur in exchange-listed issues. Though rare in penny stocks, they aren’t unknown. Two years ago, Lithium Exploration Group (LEXG) enjoyed a spectacular run that left some small broker-dealers in ruins. More recently, Lot78 Inc (LOTE) experienced an even more impressive squeeze, which has been discussed at length in an article at this site. The fun and games with LOTE began nearly a month ago, and still aren’t over.
A short squeeze will result if one or more MMs sell naked into buying pressure and become trapped. But these people are professionals, and can nearly always avoid that outcome. Contrary to what’s said at countless penny stock conspiracy websites, they don’t short willy-nilly, in an effort to “destroy” companies. They make their livelihood trading the stock of those companies. Why kill the golden goose?
Resist the siren song of those who’ll tell you every poorly-performing penny stock is a tragic victim of NSS. It just isn’t true.