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"You need people like me. You need people like me so you can point your "f***in' fingers and say, "That's the bad guy."

- Al Pacino as Tony Montana, Scarface

The world is full of mythical creatures. Some are born purely from human imagination to frighten disobedient children into compliance, such as the Bogeyman. Others are based on old legends but are given new life by cheeky pranksters, as happened with the famous 1967 Patterson-Gimlin "Bigfoot" footage. Some have a basis in reality, but have been so warped and twisted over time that they barely resemble that original reality. In the investing world one such creature is the "naked short".

What Is A Naked Short?

As quick background, when an investor or trader wishes to sell a stock short, he must borrow the shares from a current holder. He must return the shares at some point in the future, hopefully with a profit as he sells those borrowed shares and buys them again later at a (hopefully) lower price. Owners lend out securities in exchange for fees paid by borrowers which can range from modest to substantial (as in the case of heavily shorted names such as Unipixel (NASDAQ:UNXL) and Interoil (NYSE:IOC). The SEC offers a good overview with some examples here.

A "naked short" is simply the selling of securities in the market that a short seller does not own and has not borrowed.

Basis In Reality

In the olden days (before 2005), short selling was regulated but less strictly so. In 1938 (yes, your grandpappy may have been a short seller) the SEC adopted Rule 10a-1 to restrict short selling in a declining market. This became broadly known as the "uptick rule" which provided that a listed security may only be sold short at a price above the price at which the immediately preceding sale was effected or at the same price if the preceding trade was an uptick.

Over time the uptick rule grew less and less potent, as an increasing number of legitimate exemptions were granted (e.g. hedging of option positions, basket trading, market making, and others). Another problem with the ~70 year old rule was it was designed for low-volume open outcry and paper-based trading of the 1930s with 1/8 ($0.125) bid increments, not the $0.01 increments and massive electronic-based trading of modern times. With the sheer volume of trading and $0.01 increments one could see several upticks per second, and with the legitimate exemptions, it was clear a new regime was needed.

In the mid-2000s after much study, the SEC implemented "Regulation SHO" which came into effect on January 3, 2005. With additional modifications and amendments over the subsequent years, Regulation SHO brought into force several modern and comprehensive short selling regulations including:

  1. Implementation of a "locate" requirement for short sales. This requires short sellers to locate a source form which to borrow the security that they are selling prior to initiating the short sale.
  2. Requirement for clearing broker-dealers to promptly close out any "fail positions". A failed trade simply a trade that fails to settle (e.g. because the seller could not deliver the securities for settlement.
  3. Modification of the uptick rule. Under Regulation SHO, the uptick rule only goes into effect temporarily if a) fails to deliver on a stock are above certain thresholds, or b) if a security declines by 10% or more during a trading session (a "circuit breaker", thereby allowing long sellers to sell first in a declining market.
  4. Daily public disclosure of trade failures and companies on the Reg SHO "threshold list".

Among other things, these new regulations where designed to curtail trade failures (generally people that buy a security expect its delivery!) and to prevent the potential for "abusive naked short selling". Trade failures and naked short selling are linked, as a naked short sale results in a failed trade (the securities cannot be delivered). However, it is important to note that not all failed trades are due to naked short selling - they can relate to back office errors (e.g. delivering the incorrect securities, wrong or missing account information, etc.).

The data confirm that these measures have been quite successful. A study conducted by the SEC's Office of Economic Analysis conducted after the initial Reg SHO implementation found that the average aggregate fails to deliver declined by 34% after the Reg SHO effective data. Notably after the adoption of Rule 204T in 2008 (the "close out" rule requiring dealers to close out failed positions by the next morning), a 2011 study by the SEC noted that average daily fails declined by a further 65.7% across all securities and 85.1% for threshold securities (just since the 2008 amendment). Below are a few charts from the SEC report that outlines the improvement only since 2008:

(click to enlarge)

(click to enlarge)

A recent SEC charge and fine against the Chicago Board Options Exchange illustrates the teeth of these regulations.

Adding to market transparency, the SEC now provides, on a bi-weekly basis, the fails-to-deliver data on every listed equity. The files can be found here.

Despite hard data that shows naked short selling (and the resulting fails to deliver) are dramatically lower than they have been historically, and despite the ability to examine the data on stock via data from the National Securities Clearing Corporation via the SEC, and despite that fact that people buying securities that don't get delivered might actually do something about it, many investors have seemingly convinced themselves that not only is naked shorting rampant and out of control, but so much so that it is artificially suppressing the prices of their beloved stock holdings.

Not only is The Chupacabra real, they've determined. He's in their kitchen eating a sandwich and the family dog is next.

Examples of this superstitious behavior abound. To chose one, let's examine some recent comments on Bigfoot, errrr, The Naked Short from some followers of InterOil on various message boards. Names are withheld out of respect for the contributors:

"naked shorting from serious offshore money"

"Naked shorting like a rabid dog today"

"IOC on the SHO list I'll bet again..What a great SEC we have for the manipulating crooks...They could care less about our do nothing SEC......Think they had Madoff brought to their attention how many times?"

"going forward, this in and of itself, ought to put the naked short sellers on notice and presumably curtail some of the illegal reckless shorting."

"assuming being Naked with shorting more might not be the direction the crooks take...My view is there are very large numbers of naked crooks short in IOC..We have a non existent SEC at the wheel NOT enforcing what is clearly the case in my view. Perfect climate for the crooks working their magic ..Why not ?"

"lots of naked shorting today guys..My bet at least....next short count near 13 million? Sure wish the SEC would take a peak at the sheer magnitude of the short count and the huge number naked within that group of burbots.."

You get the picture. A search for the word "naked" on the Yahoo! Finance IOC message board returns over 2,000 hits.

Researchers into behavioral finance have noted a phenomenon known as "self-attribution bias". James Montier of GMO describes self-attribution bias as:

"Self-attribution bias is our habit of attributing good outcomes to our skill as investors, while blaming bad outcomes on something or somebody else."

Given this tendency, it's not surprising that during general market swoons or large declines in individual stocks we often witness lamentations about short sellers, including their more insidious cousins, the naked short sellers.

To illustrate, below is a chart of the S&P 500 since 2004. Mapped against this are Google searches for "naked short" as reported by Google Trends.

(click to enlarge)
Source: Google Trends, Yahoo! Finance

One can see in the chart above that during market declines, the villagers go hunting for the monster that has been eating their goats.

Back to our InterOil example, the chart below shows the actual fails to deliver from May 2007 to May 2013:

(click to enlarge)
Source: failstodeliver.com

Along with the general market data, one can see that trade failures have been relatively minor since the 2008 financial crisis and the implementation of Rule 204T (the buy-in rule). Year-to-date, trade failures have averaged just over 70,000 shares, with a median of approximately 33,000 shares vs. average trading volume of over 700,000 shares. Note that many of these fails would be of the run-of-the-mill kind, and a failed trade results in a forced buy-in by a clearing broker.

Confirming this, IOC has not been on the Reg SHO Threshold List since February 13, 2009. The daily files and criteria for inclusion on the list for NYSE-listed firms can be found here.

Like Bigfoot, Chupacabra, Loch Ness Monster, Bogeyman and the rest, there will always be a group of true believers. No amount of scientific proof or common sense will convince them that The Naked Short is out there ready to sink its fangs into their portfolios. One of the more entertaining sightings has been the "Naked Intraday Short". Conspiracy theorists argue that to skirt Reg SHO (illegally), naked short sellers sell during the day and cover by the end of the day. An interesting thought although if their buys equal their sells it's hard to see it having much of an impact.

It might be best to keep your goats in the barn just in case.

"Given the scientific evidence that I have examined, I'm convinced there's a creature out there that is yet to be identified"
- Jeff Meldrum, a professor of anatomy and anthropology, Idaho State University

Source: Bigfoot, Bogeyman, Naked Shorts, And Other Myths

Additional disclosure: This article reflects my personal views only. I have a short position in IOC, and it is not naked. I am not a lawyer and references to Reg SHO and other securities rules may be incorrect, outdated, or incomplete. All data and calculations presented are accurate to the best of my knowledge but have not been vetted, checked, proofread, or independently verified. This article should not be relied upon for any purpose other than for entertainment. I welcome comments and or corrections. I cannot disprove the existence of Bigfoot or any other creature.