What Traders Need to Know About Naked Short Selling

By Wayne Duggan

Short selling has gotten a lot of attention on Wall Street lately thanks to groups of online retail traders orchestrating targeted buying campaigns in some of the market’s most heavily shorted stocks. As a result, so-called “meme” stocks like AMC Entertainment Holdings Inc. (NYSE: AMC) and GameStop Corp. (NYSE: GME) have skyrocketed, forcing many short sellers to exit their positions.

At one point in early 2021, GameStop’s short interest was above 130% of its float, which raised suspicion that hedge funds were opening naked short positions in the stock.

Short Selling vs Naked Short Selling
Typical long-term investors buy shares of stock with the hope its price will rise over time. Short sellers make the opposite bet. They borrow shares of stock, typically from their broker, and then sell them in the hopes they can buy them back at a lower price in the future and pocket the difference.

Not only is short selling perfectly legal — it is a normal part of a healthy market. Investors may not like it when short sellers bet against stocks they own, but short sellers have historically played an important role in rooting out fraud and deception in the market and helping with price discovery.

Naked short selling, on the other hand, is illegal. Naked short selling involves selling shares of stock without borrowing them first. Essentially, naked short selling is selling synthetic shares of stock in an attempt to artificially drive a stock price down.

Rehypothecation’s Role
When a stock’s short interest relative to its float gets above 100%, it’s easy to see why traders would be suspicious of naked short selling. However, a phenomenon known as “rehypothecation” is often to blame.

To legally open up a short position, a trader must first locate shares of stock to borrow. If a trader borrows 100 shares of stock and then sells it, the trader has opened up a 100-share short position. However, the person who bought those 100 shares can then turn around and lend them out to another short seller who can open up an additional 100-share short position. As a result, a 200-share short position is temporarily opened using only 100 shares of borrowed stock. 

Because brokers are not legally required to disclose that shares were borrowed by the seller, rehypothecation occurs in the market without any party breaking security laws.

Naked Short Selling and the SEC
The U.S. Securities and Exchange Commission’s Regulation SHO covers short selling and is enforced by the Financial Industry Regulatory Authority.

Disclosure: The author holds no positions in the securities mentioned.

Active Trading with Lightspeed
Lightspeed provides professional traders with all the tools required to help them find success in stock trading, and we have been developing and honing our active trader platform to offer an optimal user experience. With the intuitive interface layouts and institutional quality stock and options scanners, we aim to help traders reach their goals, no matter what their strategy is. We also offer our clients some of the lowest trading fees in the industry.

For more information on a professional trading platform with Lightspeed, please call us at 1-888-577-3123, request a demo or to open an account.

Lightspeed Financial Services Group LLC is not affiliated with these third-party market commentators/educators or service providers. Data, information, and material (“content”) are provided for informational and educational purposes only. This content neither is, nor should be construed as an offer, solicitation, or recommendation to buy or sell any securities or contracts. Any investment decisions made by the user through the use of such content is solely based on the users independent analysis taking into consideration your financial circumstances, investment objectives, and risk tolerance. Lightspeed Financial Services Group LLC does not endorse, offer nor recommend any of the services or commentary provided by any of the market commentators/educators or service providers and any information used to execute any trading strategies are solely based on the independent analysis of the user.

You may also be interested in...

Bank Stocks Kick Of Q3 Earnings Season With A Bang
Read More
The IPOX® Week, October 18th, 2021
Read More
4 Bad Habits That Stock Traders Should Break
Read More
Understanding the Difference Between Option Volume and Open Interest
Read More

Try the demo

Compare Platforms
Check the background of this firm on FINRA's BrokerCheck

Our website uses cookies to improve the performance of our site, to analyze the traffic to our site, and to personalize your experience of the site. You can control cookies through your browser settings. Please find more information on the cookies used on our site in our Privacy Policy. By clicking OK, you agree to allow us to collect information through cookies.

OK