11/09/2008 05:12 am ET Updated May 25, 2011

What Is A Naked Short?: Short-Selling Definitions

During the present economic crisis, the American public has been pelted with terms like "credit default swap" and "naked shorting," which are enough to make one throw one's arms up in despair, but for the fact that one's arms are already up in despair. It's that sort of year.

So, here's an attempt at getting to the definition of naked shorting in a manageable way, with the help of the Internet.


First, what is short selling?

*When investors call a broker to arrange to borrow stock to short, they are aware that short sales are subject to a standard three-day settlement period. This means the sell-side broker has three days to deliver the shares to the investor.

*The broker is supposed to locate shares available to short prior to executing a short sale and make a determination that the shares will be delivered to the investor within the three- day settlement window. However, there are certain exceptions to that rule.

*Some shares are on an "Easy to Borrow" list. For a stock on that list, investors can execute a short sale and the broker does not specifically have to locate, or contact the source of the shares that are being shorted. The broker has a "blanket" assurance about the borrowing capability for that security.

* There is also a "Hard to Borrow" list for securities that are difficult, or unavailable, to borrow. To short stocks on the "Hard to Borrow" list, brokers have to take additional steps to ensure that the stock is available to be shorted.


That's not so easy to wrap your head around on the first read, so here's a useful explanation on how and why short selling might happen:

Short selling is like borrowing a pound of tea while the price is say, $5 per pound and selling it at that price. Then when the price drops to $3, you pay the current price to the person you "borrowed" it from, netting $2.


Now, how does a short become a naked short?

* If, for whatever reason, the shares are not delivered within the three-day settlement window, this is called a "fail to deliver."

* That "fail to deliver" essentially leaves the short- seller "naked," meaning he did not actually possess the shares he has sold.

* If shares have not been delivered for 13 days after a transaction has occurred, the broker must buy them back.