Denninger explains naked shorting in laymen’s terms

The normal way Joe Basement shorts a stock is to “borrow” the shares and sell them into the market, betting that the stock will fall, and he will be able to buy the shares back for cheaper, before he has to return them. There is nothing wrong with this, and in fact is part of a healthy market. Putting on a short squeeze (betting against the short), as we have seen the past few days, is also perfectly fine, so long as motives are out in the open, no deception/manipulation.

But we do have a problem. You see, Big Hedge gets to play by a different set of rules. Big Hedge is allowed to naked short, which means they can sell the shares into the market without acquiring them first. You can imagine how this could become problematic? It means that the short float (numbers of shares shorted) can become disconnected from the reality of total shares outstanding. Denninger:

If you want to short a stock you are supposed to first borrow it.  That is, ordinary people cannot sell what they don’t have, so if you wish to short you must first borrow that which you want to sell.  This is one of the ways brokers make money; they keep all the stock their customers have in “street name” and keep track of who has what.  They can (and if supply is limited do) charge you to borrow that stock.  There’s nothing wrong with this, provided the stock borrowed is real.  It’s one of the things you agree to allow if you have a margin account; as part of the “price” of that privilege the broker can loan your stock to others for the purpose of shorting it.  However, since you own it if you demand it back because you wish to sell it the broker either has to find some other set of shares to replace what he lent out of yours or the short-seller is forcibly bought-in at the market because they have to return your shares.  If that causes to take a loss, tough crap.

Yes, I’ve been forcibly bought-in before.  It’s a risk of the game.

There is an exception to this rule: If you are a market maker then you can short naked, that is, without borrowing first.  Why?  Because a market maker’s job is, as the name implies, to make the market — that is, to take the other side of whatever the customer wants to do.  If I want to be long something in order to do it someone else has to sell it.  Now in the physical security market this is easy; there either is or is not what I want to buy out there on the sheet offered by someone else.  But in the options market there is no physical security; the entirety of it is synthetic.  This means if someone wishes to buy a CALL someone else has to sell one.  The MM’s job is to, when necessary, be that other person.

Well, that’s dangerous because naked short options positions are obligations to deliver. 

He has a lot more to say, as you might imagine:

2 thoughts on “Denninger explains naked shorting in laymen’s terms”

  1. I’m still trying to wrap my mind around this whole thing, but that explanation helps somewhat. I think I would do better just playing “Monopoly” :-p To me, this whole thing is like playing with imaginary money which you don’t actually have to make more money at other people’s expense. I’m glad that I never had any interest in the stock market, etc.
    Thank you, Mark.

  2. So a short is like leasing a car, and selling it, under the theory that when the time comes to return the car at the end of the lease, you will be able to buy the same make/model/year to return to the lessor for less than the purchase cost plus lease payments? I lease a 2020 Jeep for total payments of say $5000 ($500/mo for 10 months). I sell it on day 1 of the lease for $30k. I anticipate being able to buy a used 2020 Jeep ten months from now for $20k, which I then return to the lessor. So I made $5k on the deal: sold for $30k – ($5k lease pmts + $20k purchase of replacement Jeep) = $5k. A naked short would be selling a Jeep I didn’t even lease, on the theory that I would be able to buy a cheaper Jeep to deliver to the buyer? That seems really fishy, or at least ridiculously risky. The naked short sounds much like a species of futures contract.

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