What To Know About Naked Shorting

Naked shorting is the illegal practice of short-selling shares that have not been affirmatively determined to exist.

A naked short means a trader believes the future value of the stock will be worth so much less than its current value that they ask a broker to lend them artificial shares to further increase their position’s profitability.

In comparison — and legal — a long position means a trader believes the future price of a stock will be worth more than its current price. A short position means a trader believes the future price of a stock will be worth less than its current price.

Remember the GameStop Corp. GME phenomenon?

Melvin Capital was estimated to have borrowed 177% of the stock’s float to be a naked short. In other words, if there were 100 shares of GameStop available for purchase or sale, the short would have been allowed to borrow 177 shares.

While there are many parties that oversee naked shorting, the fundamental practices are blurry and marginally enforced. For a naked short, a hedge fund usually asks the prime broker for naked shares.

SEE ALSO: Why Naked Short Selling Is Not As Prevalent As You Think

Unlike a conventional short in which the borrower and prime broker must locate the shares before they are borrowed (make sure the shares exist), naked shorting requires no proof that either the borrower or broker can cover their position or prove there are enough shares in a stock’s float to borrow their desired amount.

In other words, no one checks to make sure a naked short is borrowing more shares to short than shares in the float.

This may have been the reason GameStop’s short squeeze was so brutal on Melvin Capital’s bottom line. The fund borrowed more shares than shares in existence and couldn’t possibly cover its short position when the stock price explosively rose from $4 to ultimately $483.

Many believe GameStop's stock popularity and relevance were the only reasons Melvin Capital’s prime broker forced a cover. In a conventional naked short position, the fund has the option to “Fail To Deliver,” meaning that when a margin call comes the firm can declare an FTD and is given another day to cover their position.

The catch: FTD’s can be claimed every day and there is no limit in place to limit the number of times a firm can fail to deliver before it ultimately covers its entire short position.

While GameStop and AMC Entertainment Holdings Inc AMC opened the public’s eye to the illegal practice of naked shorting, it’s important to understand that this practice is as old as the traded market.