The basic form of short selling is to sell shares that you borrow from an owner that you do not own. In essence, it delivers borrowed shares. Another way is to sell shares that you do not own and that you are not borrowing from anyone. In this case, you owe the shares short to the buyer, but are “not delivered.” This form is called a naked short sale.
Bare shorting is the illegal practice of selling short stocks whose existence has not been affirmatively determined. Typically, traders must either borrow a stock or determine if it can be borrowed before selling it short. Due to various loopholes in the rules and discrepancies between paper and e-commerce systems, short circuits continue to occur.
These short sales are almost always done only by option market makers because they supposedly need to do so to maintain liquidity in the options markets. However, these option market makers are often brokers or large hedge funds that abuse the option market makers exemption.
Short without fail in delivery
There is another form of short selling, which I describe as synthetic short selling. This involves selling calls and / or buying put options. Selling calls causes you to have negative deltas (an equivalent position in negative stocks) and so does buying put options. Neither of these positions requires borrowing or “deferring” shares.
A necklace is nothing more than a simultaneous sale of an out-of-the-money call option and a purchase of an out-of-the-money put with the same expiration date. Another way to sell short is to sell a single stock future, which is equivalent to selling short. However, no shares are borrowed and no shares are undelivered.
Prepaid forwards and swaps are sometimes used to short sell. However, these are made directly between the client and some bank or insurance company, many of which have become suspect in terms of their ability to guarantee the other party.
Holding any of the above positions alone or in combination with another essentially gives you a negative delta position so you will make a profit if the stocks go down.
Margin requirements and money transfers
The following is exactly what happens when you short sell as mentioned above. You decide to sell some stocks that you don’t have because you may want to reduce the risk of other long positions you may have or you want to make simple bets that the stock will go down.
For example, you borrow shares that you want to short sell and instruct your broker to sell 1,000 shares at $ 50. At the time of sale, the $ 50,000 is credited to your broker’s account (not your account like some they may think. This distinction is important.) You must then advance the required initial margin to your account to guarantee the broker that there is money in your account to cover any losses that you may incur if you lose on the short sale. The short seller must maintain the minimum maintenance requirement on his margin account. Of course, if the short seller is the broker, then both the broker account and the short seller account are essentially the same.
The broker earns interest on the loan of the short sale proceeds to other clients on margin. That lender becomes a short seller when the broker is a short seller. When the broker acting as the options market maker makes a short sale, he does not need to borrow shares and instead collects all the interest on the earnings for himself.
If the stock falls after the 1,000 shares are sold to $ 50, say to $ 45, then $ 5,000 is transferred from the broker’s account to the short seller’s account, which can be eliminated by the short seller. Your margin requirement is reduced by 50% of the $ 5,000. On the other hand, if the stock rises to $ 55, then $ 5,000 moves from the short seller’s margin account to the broker’s account and the short seller’s minimum maintenance requirement will increase.
These money transfers are done in exactly the same way, whether you are running a regular short sale or a naked short sale. There are similar future transfers if you have sold calls or sold individual stock futures. When you buy put options and pay them off in full, there are none of these post-purchase money transfers, although the value of your account certainly fluctuates as the value of the put options fluctuates.
All of the above ways of getting negative deltas put pressure on the stock value similar to how direct sales of long stocks put pressure on the stock price. Also, these short selling methods are sometimes used by those who have inside information about some negative future event to make illegal profits by selling or shorting stocks prior to the announcement of that future event. Combinations of previous positions with long positions, where aggregated net short equivalent stock positions are created, are often used to disguise illegal insider trading.
Short selling is often in the news today and is criticized by journalists and other experts who claim that short sellers ally themselves with “rumor mongers.” caused the collapse of Bear Stearns and Lehman Brothers. They cite the large “non-delivery” of a stock as evidence of naked short selling days after the stock had fallen. Although naked short sales happened after the crash, they still cling to the idea that those naked short sales after the event caused the crash.
In my opinion, those who believe that short selling caused the collapse of Bear Stearns and Lehman Brothers are diverting attention away from illegal insiders and their manipulative allies.
The large volumes of stocks that “failed to deliver” and the short selling after the Bear Stearns and Lehman Brothers collapses lead me to believe that there is an explanation for those large volumes. However, that strategy did not cause the collapse of those companies.
The bottom line
Selling short can be done in many ways. And while the naked short sale often gets a bad rap in the media because it is frequently abused, it is not as dire as its critics suggest.