Naked Versus Covered Short Selling

Short selling a stock is the process of borrowing a stock, selling the stock, with the intention of repurchasing the stock once the market falls to a lower level.  Investors can incorporate short sales into numerous types of strategies which include outright short sales, pair trading, and option trading.  Investors can also use short selling to hedge risk exposure.  Short selling is categorized into covered and naked short selling.

How to Short Sell

To short sell a stock, an investor needs a margin account in which they can borrow funds which allows them to initiate a short position.  The stock is borrowed using collateral, sold and then repurchased.  Generally, the less liquid the stock, the harder it is to borrow.  When borrowing a stock, the lender is collateralizing the transaction against the stock that will be returned to it by the short seller.  This standard process is called covered short selling.

When an investor shorts a stock he is taking market risk that is without bounds.  Theoretically, a stock price is bounded by zero on the downside, but can rise to an infinite number, which can generate significant volatility.  Short selling is used as a strategy that anticipates a price fall, but generates upside market risk.

Naked Short Selling

Naked short selling occurs when an investor shorts a stock without first borrowing the stock. In theory, an investor needs to own a stock before he sells the stock, but in some instances this practice cannot be achieved.

If the short seller of a stock does not acquire the stock prior to the required deliver period, the result is known as a failure to deliver. This type of transaction will remain open until the stock is obtained by the seller.

In 2008, the SEC banned naked short selling as a method of driving down share prices and creating negative momentum. Failing to deliver a stock and naked short selling is not necessarily illegal.

Naked short selling can create a momentum affect where a stock price tumbles if an investor can sell rapidly without borrowing against the stock.

Why Naked Short Selling Occurs

If the inventory of a stock is in limited, finding shares of the stock to borrow can be formidable. A seller may decide that the lack of availability of the stock or the cost of the borrow make creating a covered position unattractive. If there are few lenders, the interest rate that a lender could charge might be prohibitive.

Naked short sales can take place in a liquid market which may not be noticed. If the shares of a short sale cannot be obtained, the trades will fail. Failure reports are published regularly by the SEC, which might generate unwanted attention to the short seller.

When an investor repurchases a shorted stock, the transaction is referred to as “covering short positions”.  Shorting a stock creates liquidity within a market place.

Strategies

Investors will use short sales for many types of trading strategies.  The most widely known is directional short selling in which a seller looks for a stock to move lower.  Some traders will generate pair trades in which they purchase a stock and simultaneously short sell another similar stock looking for the spread between the two stocks to move in a specific direction.

For example, many investors pair trade highly correlated companies, such as Coca Cola and Pepsi (those that move in tandem) which are in the same businesses to generate robust returns.

Investors will also use short sales to hedge a portfolio of positions.  Short sales of indexes such as the S&P 500 index are a popular method used to hedge a portfolio of stocks.  For example, if an investors has a portfolio of large cap stocks and believes that current conditions might lead to an adverse downside decline in stock prices, they could hedge their portfolio by shorting the Spider Select S&P 500 ETF (NYSE:SPY) to hedge their portfolio.

There are also a number of options strategies in which an investor purchases an option and simultaneously short sales the stock which is the underlying position created by the option.  For example, if an investor has long call position in Apple, they could sell short Apple stock to hedge their option position.

Summary

Short selling is a very important part of market liquidity.  Allowing investor to short sell plays an important role in the capital markets, however the risks associated with naked short selling can be extreme as there is no limit on the potential losses.