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The SEC has announced that it will be reviewing and revising the short selling rules that currently exist in the financial markets. Naked short selling has come under scrutiny by both the media and the average investor trying to comprehend why the markets have fallen like they have.
Naked short selling is the practice of selling a short stock without actually checking to make sure if the stock is available; this often creates a situation where “phantom shares” are created. Ultimately, more shares are trading hands than truly exist, and therefore, the company that is represented succumbs to low stock prices as the result of more selling than buying. It's impossible to buy more shares than exist, but short selling is a whole different realm.
Naked short selling has no place in the market
The opinion of the average investor is that this practice should have been banned long ago. The problem is that naked short selling was banned – it has just not been enforced. The large institutions have been able to generate large volumes of cash with the practice, and they’re plenty happy to do it. Here is how the override the ban – and how they’re stealing billions from the small players around the world
Selling short means that you’re selling shares before you own them; therefore, you’re taking the value of the stock in full so that you can buy it back later. For example, selling short 1000 shares of Yahoo stock means that you’ll reap an instant gain of about $20,000. But that is just the beginning of the equation; there is much more to naked short selling than this simple explanation.
Reinvesting the proceeds
Short sellers take the capital they receive from selling short and can reinvest it in anything. Analyzing our previous example of selling 1000 shares short of Yahoo, you would have $20,000 to reinvest. This is a lucrative form of leverage that institutions, not average investors, can utilize to double profits. Investing that $20,000 even in the safest of investments will yield an additional $1000 per year – and that is profit from borrowed money. Institutions are able to generate huge profits that you would never expect from this practice, and unlike the example, they aren’t selling just 1000 shares short, but millions.
The power of numbers
This is where short selling becomes most profitable. Institutions are able to sell short smaller companies to the point that they’re no longer able to function. If a company with a market cap of $250M is sold short to the point of 80-90% of the total float by one or many institutions, the simple mathematics behind market dynamics would tell you that the stock is going to zero. There’s absolutely no risk here; institutions can win just by piling large amounts of shorts on one stock and use the proceeds to leverage into other investments. Companies will no longer be able to dilute shares to raise capital, and very few people are willing to buy convertible bonds when a stock price is tanking; couple this with a company that is already losing money, and you’ve have an instant failure on your hands.
All these ramifications are forcing the SEC to re-evaluating short selling – and how they can enforce the ban of naked shorts on institutional traders.