Naked Short Selling


Shorting and "Longing"

I have already discussed what it means to take a long position or short position, here  Price with Time but here is a summary followed by a more detailed explaination;

Long Position - Traders who believe the price will rise will try to buy at a low price and later sell at a higher price so as to make a profit. In the financial markets this is called taking a long position.

Short Position - Traders who believe the price will fall will try to sell at a high price and later buy at a lower price so as to make a profit. In the financial markets this is called taking a short position.

Let us imagine the market for a fictitious valuable. For each unit of valuable in existence there is a certificate of ownership and these are bought and sold on the open market.

These certificates are sold by producers and bought by consumers of the valuable. Supply and Demand determines the price quite well providing an economic signal to increase or decrease production over the period. This is an example of a working free market.

The market consists of a broker whose sole function is to facilitate trade in these certificates. Anybody can register with the broker to buy and sell these certificates including traders who are neither producers nor holders, nor consumers of the valuable. The traders objective is simple, buy certificates when they are cheap and sell them when they are expensive.

The price of the certificates will vary as speculation as current supply and demand and speculation about future supply and demand varies. Producers and consumers need price stability to run their businesses, but traders need price variation to make a profit.

So traders will encourage speculation and try to create waves in the market price.

This is a physical market. In this kind of market at any given time the broker has producers selling certificates and consumers buying certificates and a huge numbers of speculative traders some wishing to buy and some wishing to sell with an eye to the profits they hope to make.

Clearly these speculative traders are interested only in profits (and losses) and not the valuable its self. If some speculators wish to buy valuable now to sell it back to the broker later and other speculators wish to sell valuable now to buy it back from the broker later, then there is little need for anybody to actually transfer physical valuable because it will only be going back later. Of course all buy contracts must have the right to ask for the physical valuable if the buyer so wishes and every sell contracts must have the obligation to supply the valuable if asked. But this rarely happens.

So the broker generally does not provide any valuable to the buyer but the buyer has the right to ask; 

The broker simply opens (agrees) a contract with the speculator to the effect that when the contract is closed the broker will transfer the difference between the closing price and the opening price of the valuable to or from the speculators account with the broker. the resulting profit or loss for the speculator will be exactly as if they had bought an amount of the valuable at the opening price and then sold it at the closing price.

When a speculator opens a contract of this form they are said to have opened naked long position in the valuable concerned.

So the broker generally does not riquire any valuable from the seller but has the right to ask; 

The broker simply opens (agrees) a contract with the speculator to the effect that when the contract is closed the broker will transfer the difference between the opening price and the closing price (notice the reversal) of the valuable to or from the speculators account with the broker. the resulting loss or profit for the speculator will be exactly as if they had sold an amount of the valuable at the opening price and then bought it at the closing price.

When a speculator opens a contract of this form they are said to have opened a naked short position in the valuable concerned.

Now this is a virtual market and is different from the physical market mentioned above.

Tying Physical and Virtual Markets

What is the relationship between a physical and virtual market? How do prices in one effect prices in the other?

Because every contract either gives the right of delivery of valuable or the obligation to supply valuable the virtual market and physical market prices are intimately tied into one another.

Where the virtual market trade volumes exceeds the physical market trade volumes i.e. most buying and selling is done by people whom never produce, store or consume the valuable in question the physical traders are tied into prices that are set by the actions of the virtual traders.

As has been said physical traders need stable prices where as virtual traders need unstable prices. Where the virtual traders are the vast majority, they may well have their way and price will end up being determined by the speculators superstitions such as "Fibonacci retracement" rather than genuine supply and demand issues which are far better understood by the physical traders. 

A Los Angeles Times editorial in July 2008 said that naked short selling "enables speculators to drive down a company's stock by offering an overwhelming number of shares for sale."

Virtual traders trade contracts containing rights to demand and obligations to supply which they do not often fulfil which is not quite the same as trading the physical valuable its self.

Even now in the US short sellers appear to have 3 trading days to supply shares they have sold according to the Security and Exchange Commission. See Wikipedia - Naked short selling
This is of course quite long enough for most short sellers to open and then close a position for profit, and thus fill the market with virtual i.e. phantom shares which dilute the real shares. When a short seller does not supply the shares it is called a "Fail to Deliver". To find out the number of failures to deliver on any given share ticker use the link Fails to Deliver

Speculators claim that taking short positions adds to liquidity in the market. They are quite right about that in that it does add a virtual supply to the physical supply bringing the price down. But they conveniently ignores the fact that it is speculators taking long positions that takes away liquidity from the market in the first place tying up both the physical and virtual supply.

The net result is that speculators do most certainly increase price instability by swamping real physical trades with speculative virtual trades, endeavouring to drive prices up and down through collective action so as to collect the difference with no concern for the effect on the underlying physical trade chain.

Nowhere is this better seen than in the FOReign EXchange market where by far the majority of trades are speculative causing price variations that destroy international trade where profit margins are sensitive.

Some speculative traders have become a form of parasite and a destructive force to the natural balance of the free market. The regulators need to ensure that parasites are removed from the financial markets. The difficulty is that in the US employees of the Security and Exchange Commission look to gain future employment with the organisations they are charged with regulating.

To get some idea of the extent of the decay see Deep Capture and watch their movie.
 
Robert J. Shapiro, former undersecretary of commerce for economic affairs, and a consultant to a law firm suing over naked shorting, has claimed that naked short selling has cost investors $100 billion and driven 1,000 companies into the ground.

Of course there is extreme resistance to this regulation. See 2009-08-05 Former Enron trader calls for setting commodities limits and I quote;

But he also emphasized that position limits should only be added on futures contracts that result in physical delivery, and cash-settled financial contracts should not be limited.

So don't limit the actual cause of the problem and the source of his profit!

Limiting financial contracts will "have a range of detrimental effects on the market," he said, including pushing trading activity to over-the-counter trading, increasing volatility, and reducing liquidity.

More likely to reduce volatility, as explained above, as it would kick virtual traders out!

Physical futures are the most traded contracts and are widely used by commodities users such as airline companies to hedge their risks.

Arnold argued that financial and physical contracts are not "fungible," and trading financial contracts "doesn't itself create volatility."

I don't think that is true as if the two contracts were not fungible they would potentially form two different markets!

Last year his fund Centaurus Energy returned 80%, according to Alpha magazine, resulting in an estimated $1.5 billion in personal earnings.

Not bad for a business that contributes nothing!

Arnold, who joined Enron Corp. after graduating from Vanderbilt University and left the bankrupt energy giant untainted by charges related to its electricity trading practices, has emerged as one of the most successful hedge-fund traders in recent years.

Ah! Enron, they never lied. For more on Enron see below.

And just to round off the evening a little gem;
This video tells a story of naked short selling.

YouTube Video






(C)2010 Tom de Havas. The information under this section is mostly my own work it may be reproduced without modification but must include this notice.







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