What is Short Selling?
Short Selling is an investment strategy which makes a bet that a company's stocks is overpriced and will likely fall. Using an analogy helps to explain a process which few retail investors actually understand. Pretend that you borrowed your neighbor's lawn mower, which your neighbor generously says you may keep for a couple of weeks while he's on vacation. You're thinking of buying a lawn mower anyway so you've been researching the latest sales and have seen your neighbor's lawn mower on sale for $300, marked down from $500. While you're mowing your lawn, a passerby stops and offers to buy the lawn mower you're using for $450. You sell him the lawn mower, then go out and but the same one on sale for $300 and return it to your neighbor when he returns. Only now you've made a $150 on the deal.
Let's return to the stock market where similar principles apply. You believe Amazon is overvalued and its price is going to fall. So as a short seller, you borrow Amazon stock which, like the lawn mower you don't own, from a broker and sell it into the market. As long as the Amazon stock is in Street name or in the brokerage firm's inventory, the broker has the right to lend it out to you. You borrow and sell 100 shares of Amazon at $50 per share, yielding a gain, exclusive of commissions, of $5,000. Your research proves correct and a few weeks later Amazon is selling for $35 per share. You then buy 100 shares of Amazon for $3500 and return the 100 shares to the broker. You then have closed your position, and in the meantime you've made $1500. If the stock had gone up instead of down, you would have lost money, and unlike on the long side where the limit of your loss is the original amount you invested (stock goes to zero), on the short side the potential loss is infinite as the stock can continue to go up and up.
In order to short stocks you must open a margin account because you're actually borrowing the stock rather than owning it. Most brokerage firms will not allow you to margin a stock under $3 per share (many will not allow it under $5 per share), so naked shorting is often a solution for low priced stocks.
What's Wrong with Short Selling?
There is nothing inherently wrong with short selling. As you can see from the example, it helps to correct the excesses in the market. The problem arises when short sellers use a scheme called naked short selling to effect their transactions. Naked short selling is a technique whereby you sell short without borrowing the stock. In this way short sellers can sell as much as they want with no accountability for returning the stock. This ability to "fail to deliver" the stock creates havoc in the micro-cap market. In particular shorts can pick on small emerging companies and drive their stock to zero, thus preventing capital raising and frightening other longs in the stock to abandon their position, not based on the fundamentals, but only on the manipulation of the stock. Obviously when you see your stock price plunging, you are most likely to sell first and ask questions later. Shorts were able to get away with this practice because only those firms that were NASD members were required to comply with delivery rules.
There are many groups, such as Canadian brokerage firms, Specialists, options players, who are not NASD members, and therefore do not have to comply with the NASD rules that require members to assure delivery of stock by the settlement date. For example, if you open a brokerage account at a Canadian firm, they are allowed to keep open "fail to deliver" orders on their books. A short selling group trading through a Canadian brokerage firm literally can get away without delivering their shares. In Canada, previous to the new regulation, investors were not required to borrow stock before selling it short.
The Initial Solutions
This is all coming to an end, however, as the NASD is instituting a rule, which takes effect on April 1, 2004 requiring NASD firms to treat non-member broker dealers in the same fashion as members regarding delivery of shares sold through US registered broker dealers. In addition the SEC has proposed Regulation SHO.
"Proposed Regulation SHO would, among other things, require short sellers in all equity securities to locate securities to borrow before selling, and would also impose strict delivery requirements on securities where many sellers have failed to deliver the securities. In part, this action is designed to address the problem of "naked" short selling."
With some expectations for market makers and specialists, the SEC has stated,
"Proposed Rule 203 would prohibit a broker-dealer from executing a short sale order for its own account or the account of another person, unless the broker-dealer, or the person for whose account the short sale is executed (1) borrowed the security, or entered into an arrangement for the borrowing of the security, or (2) had reasonable grounds to believe that it could borrow the security so that it would be capable of delivering the securities on the date delivery is due."
We've watched a number of companies be destroyed by illegal shorting practices, and it is a welcome relief that new rules will at least help control what has been as practice clearly detrimental to retail investors as well as small companies.
Interesting since this is the trend CMKX was following for the longest time and even then when the average investor was able to buy it at only 0.0001 there were individuals who managed to pick it up at a lower price including 0.000001
AI
