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Naked Shorting

 

For the last ten years and more, the specter of naked short selling has hung over the penny stock community.  Or so some would have it.  Unfortunately, newcomers to the markets often turn first to message boards and conspiracy websites for informBull and Bear shortingation.  At those venues, many fall prey to hysterical hoopla purporting to explain how naked shorting is responsible for the untimely deaths of “tens of thousands” of worthy startup companies, and will even one day cause the collapse of the global economy.

Don't listen.  It's hogwash. 

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The Get Shorty movement

The demonization of Shorty began in earnest in the late 1990s, when a number of penny companies began to complain about gigantic naked short positions hampering their growth and causingtheir stock price to decline sharply.  Two of those companies were Jag Media Holdings and Universal Express.  Jag had once performed a useful service, faxing out pre-market news and rumors to subscribers.  Subscriptions were expensive, and Jag did well until rise of the internet made similar information available at much lower prices, or entirely free.  Jag wasGet Shorty in trouble.  As volume rose and stock price slumped, Gary Valinoti, the company's CEO, began complaining of naked shorting activity.  He attracted a crowd of supporters, some of whom insist to this day that nothing was wrong with Jag, despite the fact that in 2005 the SEC sued Valinoti, charging him with the sale of a great deal of unregistered stock, and fining him millions.

The Universal Express story was similar, except that USXP never really got its service—a supposedly stress free luggage shipping system—off the ground.  The CEO, Richard Altomare, a scam artist with serious delusions of grandeur, eventually issued some 24 billion shares, selling most of it unregistered and without appropriate exemptions.  He, too, was sued by the SEC.  After spending some time in New York's Metropolitan Correctional Center for contempt of court, he was heavily fined.  He continues to blame the entirely mythical Shorty for his problems, and has written a book presenting himself as a martyred hero.

Both stocks enjoyed a cult following, and USXP even ran from time to time, until the SEC cracked down.  The Jag shell was eventually sold to Cardiogenics Holdings; USXP's registration was revoked.

More and more companies and their shareholders jumped on the Get Shorty bandwagon.  The NSS theories were easy to understand, and appealed to those who found it convenient to blame their losses on anyone but their companies and themselves.

 

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CMKX

Everyone's favorite NSS poster child was, and will always be, CMKM Diamonds.  CMKX, as most people think of it today, was the biggest penny scam of the first decade of the new century.  Urban Casavant, the Canadian CEO, managed to issue 800 billion shares, and planned to issue another 800 billion, until his adventure was cut short by the SEC.  Most of those shares were unregistered.  Casavant was essentially a front man for John Edwards and Jeff Turino, who'd worked together on an earlier super diluter, Pinnacle Business Management.  Casavashorting stocksnt gave Edwards enormous quantities of stock; Edwards got the stock freed up using fraudulent opinion letters and sold it into the market.  He then kicked back substantial sums to Casavant and Turino.

As always, supporters—and there were many; at one time CMKX has more than 40,000 shareholders—refused to believe anything was wrong.  Shorty became the convenient scapegoat.  Even after the SEC sued, and the Department of Justice brought a criminal action, they insisted that trillions, perhaps quadrillions, of shares had been shorted.  Some will still not be dissuaded from this belief.  A small group brought an absurd lawsuit against the SEC commissioners, incoherently alleging an elaborate government conspiracy; they wanted a staggering $3.87 trillion in damages.  Needless to say, the suit was dismissed.  Al Hodges, the attorney (and also a shareholder), appealed to the 9th Circuit and then to the Supreme Court.  Just the other day, the Supremes declined to hear the appeal. 

The Xers are crazy.  Believing that NSS is destroying our markets will make you that way.

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Regulation SHO

Naked shorting is not illegal, though it is now against SEC regulations.  For many years it occurred frequently, for the most part without any sinister intent.  If traders wanted to short an issue, they placed an order with their brokers.  The brokers would usually fill the order immediately, even if they hadn't yet managed to locate stocNaked Shortingk to borrow.  The short sale went through, and stock was located and borrowed within the next few days.  No real harm was done in nearly every case.  Still, the process was sloppy.  Stock that should have been delivered within three days often wasn't delivered for five or six days. 

Although a Federal appellate panel had upheld the legality of naked shorting, in 2004 the SEC decided it was time to do something about what was perceived, rightly or wrongly, as a growing problem.  Regulation SHO, implemented in January 2005, introduced locate and close-out procedures designed to ensure that shorted stock was actually borrowed, and that delivery actually occurred.  With Reg SHO came the Reg SHO Threshold List, which flags issues in which significant failures to deliver have occurred.  The SEC cautions that not all fails to deliver are caused by naked shorting; they can be long as well as short, or caused by other issues.  Any stock that lands on the SHO list will stay there until the threshold fails are cured. 

Reg SHO appears to be working well.  Once the list was relatively long; now it's quite short most days.  It's published every night at around 11 p.m. 

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aThe FINRA daily short volume report

In February 2010, FINRA began publishing a daily report showing short volume in all issues traded that day.  They did so under pressuExpect A Massive Short Squeezere from the SEC, who told them “transparency”—evidently  even of the meaningless kind—was required.  In November 2009, Jess Haberman, a FINRA official, expressed concerns about the soon-to-be published list, noting that:

...with respect to broker-dealer proprietary sales, especially when acting in the capacity of market makers and block positioners, such trade volume information may not always depict accurately the quantity of stock sold short.  It may tend to over-count such volume, and therefore, if published, unnecessarily impact investor confidence in an unforeseen way.

Haberman was correct.  The Get Shorty bunch jumped on it with glee, proclaiming that it “proved” naked shorting in every penny stock out there.  Worse yet, they added up the numbers from day to day, which resulted in gigantic and ever-increasing short positions for just about every penny stock.  Short numbers of any kind are never added up:  they are a running balance.  Each day, some shorts are covered; others are opened.  It's like your checkbook. 

Essentially, the short volume reports reflect MM activity.  They report nearly all trades, and only the first leg of any trade is printed.  As Haberman pointed out, the MM reporting a short sale may cover immediately, and end the session flat.  Anyone who calls FINRA to ask about all this will be told to rely on the bi-monthly short interest report, also published by them.

In the three years since the daily short volume report first appeared, not a single short squeeze could have been predicted based on the information contained therein.  Yet the NSS fanatics continue to beat the drum.

Nonetheless, websites like buyins.net, run by Tom Ronk, and otcshortreports.com, run by John Lux, claim to be able to call a squeeze based on the daily short volume numbers.  So far, they haven't been successful in doing so, though many readers mistake strong rallies for squeezes.  Buyins.net is a promotional site; companies pay Ronk to produce “squeeze trigger reports.”

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definition_short_squeeze

Short squeezes

Traders do short stocks, and market makers qualify for an exemption that allows them to short stocks naked in order to provide liquidity.  The latter must always trade against market sentiment:  if retail wants to buy, they must sell; if retail wants to sell, they must buy.  If the MM miscalculates, and finds himself with a serious imbalance he can't cover going forward, he'll be in serious trouble.  Traders too will have difficulty covering if the stock rises precipitously.  Both will be susceptible to buy-in notices from their clearing firms, and could lose very significant amounts of money as the stock rockets higher and higher.  That is a short squeeze, and for longs, a squeeze is a delightful experience.

Most short squeezes occur in exchange-listed issues.  Though rare in penny stocks, they aren't unknown.  Two years ago, Lithium Exploration Group (LEXG) enjoyed a spectacular run that left some small broker-dealers in ruins.  More recently, Lot78 Inc (LOTE) experienced an even more impressive squeeze, which has been discussed at length in an article at this site.  The fun and games with LOTE began nearly a month ago, and still aren't over.

A short squeeze will result if one or more MMs sell naked into buying pressure and become trapped.  But these people are professionals, and can nearly always avoid that outcome.  Contrary to what's said at countless penny stock conspiracy websites, they don't short willy-nilly, in an effort to “destroy” companies.  They make their livelihood trading the stock of those companies.  Why kill the golden goose? 

Resist the siren song of those who'll tell you every poorly-performing penny stock is a tragic victim of NSS.  It just isn't true.

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