What Traders Need to Know About Naked Short Selling

June 16, 2021

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.

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