When I hear people talking about the SEC and shorting (mainly on CNBC America) I see how people are mixing apples with oranges. The SEC has instituted the rule that to be able to short you need to have the shares ahead of time. The problem is that many think the SEC rule is against shorting, when in fact it is for shorting, but it is keeping the shorting playing field level.

So let me explain the shorting rule and how a naked short sale can occur.

In a “naked” short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard  three-day settlement period. As a result, the seller fails to deliver securities to the buyer when delivery is due; this is known as a “failure to deliver” or “fail.”

When you short a stock, you need to sell a stock that you don’t have. Thus you need to borrow the stock. Think of it as follows. You are selling something that you don’t have in the hopes of being able to buy it cheaper at another place and time.

The problem is that with a short you need to have a stock at hand that you will sell, and that is where the naked part comes in. If you sell a stock without having the stock at hand you are selling thin air.

Due to the way the exchanges work you are doing a naked short for most trades. This is because when you make trades there is a 3 day settlement period. If you have a cash account this means that if you buy today you will get your shares in 3 days at the latest. And if you sell you will get your money in 3 days. If you have a margin account your broker will deliver your shares immediately, and give you your cash immediately. But if you have a cash account you have to wait 3 days.

So let’s say that you short a stock, you have 3 days to deliver the shares that you shorted. And this is where many are not doing their part and leaving the short as a naked short. How do I know this? Look at the RegSHO list. The REG SHO list is a list of stocks that have not yet delivered their shares. Where things get funny is for a company like overstock.com, which has been on this list for nearly 3 years.

The problem with the naked short is that a delayed delivery can warp how a stock will and can perform. Imagine a company with a float of a 1 million shares. Some folks decide to short the stock and create a float of 2 million shares, thus creating imaginary 1 million shares. The 1 million floating shares would have to be delivered in 3 days. Thus would force the shorters to find the shares and most likely cause a rally because they would need to buy a complete float of the company.

However, since the SEC and government were dropping the ball and not going after the deliveries of shares the float of the company could remain warped. This then warps the performance of the company to the downside and is a bad for a company. But by having the SEC enforce the rule where you have to have the stock before shorting you are not warping the stock of the company.

What bothers me is when people like Richard Baker (who represents the hedge fund industry) say that this rule is an attack on shorting. On the contrary this is an attack on those who warp the performance of a company. It does not stop you from shorting a stock.

Why you ask would the hedge fund industry be against this? Simple, because the biggest abusers of naked shorts are the hedgies themselves (NOTE: This is a postulation and I don’t complete know whether or not this is correct). You see brokerages to keep their brokerage licenses don’t allow naked shorts. Banks to to keep their banking licenses don’t allow naked shorts. Though hedgies who are a special category of traders can get away with this since they are a largely unregulated industry.

The way I see is that a company who is being shorted and driven down in price is like a homeless person who is down on their luck. The banks and brokerages who do legal shorts are yelling at the homeless person to get a job and a life. The hedgies are also yelling, but kicking the homeless person in the teeth for good measure and to make sure that they don’t get up again.

Sure this is harsh comparison, but it bugs me to no end when the playing field is warped a by few players. And for those who say, “Christian you are wrong” I reply, please explain the Reg SHO list and how that is not naked shorting!