Floor traders refer to naked shorting a stock to its lowest levels as cellar boxing. It derives this name from the fact that the regulatory agencies have established a floor price at which a stock can trade. This level is set at $0.0001 or one-ten thousandths of a dollar. This level is aptly named the cellar. Reaching this floor is the goal of naked short selling as it maximizes the profits of the seller and hastens the company’s demise, removing any future liability from the seller. NASD Rule 3370 permits market makers to short sell (naked short sell) at various times for their own account including when there are significantly larger number of buy orders than sell orders. Theoretically, a market maker can sit on the ask at $0.001 to fill the orders for these micro-cap companies, reducing the risk to the market maker of a forced cover.
Jarrow (1992) details the large trades that create momentum which leads to asymmetric price elasticities between sales and purchases of stocks. The trades are large enough to create upward price momentum. This momentum is then utilized by the large trader by selling back to noise investors at a higher price. It is likely that Jarrow’s result could be extended to shorters seeking to capture additional returns. The large trader (market maker or hedge fund) short sells large positions, which create negative price momentum leading to the price cellar. This short strategy is persistent and sustainable due to the asymmetric nature of information of individual trades. This asymmetry promotes naked short selling as an attractive economic transaction for the seller.
Cellar boxing has become more popular since 1999 when the market went to a decimalization basis on stock prices. Prior to this time, the minimum market spread for stocks was set at 1/32nd of a dollar and the market makers were guaranteed a rather generous spread. Since decimalization, the spreads can be down to as much as a penny in some larger cap, highly traded stocks. As a result of the decline in income, market makers became more active in the smaller cap markets - the OTCBB and Pink Sheets. The reasoning is twofold. First, it allows a larger percentage spread on each share, as the price of the stock in question is forced down. In addition, these markets have a reputation for a reduced level of regulation where the protective effects provided by the SEC’s Regulations are not as rigorously enforced. Some examples include Rule 10-a (the tick test), and various NASD Rules including, but not limited to 3350, 3360, and 3370 (these deal with the affirmative determination in writing of "borrowability" by settlement date and allowing market makers to legally naked short sell into markets characterized by a plethora of buy orders at a time when few sell orders are in existence). Protections offered investors by these rules are either limited or suffer from lax enforcement in the smaller cap markets.
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