Exactly right, Mark. Nothing has been counterfited. It is simply a party/contraparty financial transaction.
If, for example, I sell an uncovered call contract on stock ABC, I have "naked shorted" the stock. If the stock stays at, or under the strike price I earn the time value and any premium on the option I sold. If the stock goes above the strike price I have to cover the contract at a loss, but I still earn the time value of the option I sold. In general the entire transaction is contained within the options market, and the buyer of my contract is assured of my performance by the margin requirements imposed on me by my broker in order for me to write the uncovered call.
If I sell a whole bunch of call contracts on ABC it provides a signal to the market that somebody thinks the stock is overpriced and is willing to put their money behind that belief. It could also mean that I am happy to hold the stock for its long term potential, but want to earn a premium for holding it short term. Signals in the market are never totally clear.
A "naked short" is, at its core, nothing but a single stock futures contract, selling a share of stock that one agrees to deliver at a future date.
IF it were widespread, naked shorting could have a depressing effect on share prices due to the increase in supply of the stock with no offsetting increase in demand. However, the available data simply do not support the hypothesis that the practice is wide-spread, or even that is exists at all outside of market-making and various hedging strategy.
What is far more common in penny trash issues is the orchestrated pump and dump, in which the company finds a discount CD issuer, and issues S-8 shares for "consultation" services. The consultant turns around and hires fax blast, newsletter, and message board pumpers, and in concert with management issues a series of breathless PR's that are long on promise and short on substance. The CD holder then sells into the price and volume spike with the assurance that he can convert the debenture to cover the short sales. Ultimately, the effect of the new CD shares flooding the market tanks the price, but the company has their money-to be spent by and large for management salaries and perks-the CD holder has his guaranteed profit, and the retail shareholder has been fleeced again.
The cries of naked shorting then begin, in the hopes of keeping the sheep in the pen.
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