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Naked Short Selling

Naked short selling also referred to as naked shorting is the act of short selling a tradable asset without first borrowing the security or ensuring it can be borrowed as is usually don’t with a short sale. The practice of short selling is the process of selling securities or other financial assets that are not currently own and then repurchasing them. When the price declines the short seller will profit since the cost of the repurchase will be less than the profits from the sale.

With naked short selling, the price fall is anticipated but the seller is exposed to the risk of a price rise. The most basic form of shorting is selling stock that you borrow from an owner and is not owned by yourself. Then you will deliver the borrowed shares. Another option is to sell stock you don’t own and are not borrowing from someone. Here you owe the shorted shares to the buyer but you fail to deliver. This is the basic idea of naked short selling.

Another form of short selling involved selling calls or buying puts. Selling calls means you have a negative stock equivalent position and so does buying puts.

Naked shorting, which is essentially selling stock the seller doesn’t have and hasn’t borrowed, without having security but just a hope that the price of the stock will fall quickly, then letting the seller repurchase it at a lower price point and deliver the stock to the buyer, is generally illegal.

Usually stocks must be borrowed or bought, or at least determined that they can borrow it, before being able to sell it short. Naked short selling isn’t a great idea for most investors, and there are many individuals within the financial markets that believe it should be banned completely.

Naked short selling is frowned up and is an even higher risk version of traditional form of market trading. The securities and exchange commission regulates the practice and usually steps into to stop short selling of financial socks during a credit crisis.

Short sellers are usually blamed for driving down stock prices that makes them the bane of the financial trading market. However there is little to no evidence that this is actually true. When you borrow stock you believe is overpriced and headed for a fall and then sell the borrowed stocks when the price drops you are short selling. The opposite can happen as well, where the stock price rises instead of falls and you buy back at a higher price to replace the borrowed shares.

Because any short selling is done with a margin account, the trader leverages the account to increase profits. Therefore naked short selling massively increases the level of risk, and also reward. With naked short selling the trader is selling shares they do not own or borrow which critics claim is driving down stock prices. The naked short trader does not plan to deliver the shares she shorted, the idea is to buy actual shares on the open market before the deliver day of the short sale which is usually three business days. The trader then closes out his position by buying the shares on the open market at the lower price and delivering those shares.

When traders use naked short selling to purposely drive down the price of a stock its considered illegal because they are manipulating the market that is against the law.

When the price of stock rises, short sellers are forced to buy shares on the open market to cover their position, but if enough short sellers start buying the same stock it will only make the losses increase as the price of the stock will increase.

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Rules, Regulations, and Guidelines

The Securities and Exchange Commission has places restrictions on short selling but critics claim the rules are way too lose as they change their minds a lot and lift the restrictions from time to time.

Short selling of any kind and especially naked short selling is not advised for new investors, it’s the closet thing you can get to gambling and that’s not the way to handle your finances.

Naked short selling is often in the news today, and its criticized by journalists that claim naked short sellers are causing the collapse of companies like Bear Stearns and Lehman brothers. They claim that the large “failure to deliver” for a stock as evidence of naked short sales days after the stock has dropped. Even though the naked short sales happened after the collapse, journalists and other pundits still hold onto the idea that the naked short sales caused the collapses.

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