UPDATED JUNE 4:
Question: Can you please explain what is meant by a “naked short”? I’ve heard naked shorts being referred to as counterfeit. Is that accurate?
Paul Solman: First, let’s define a “short” or “short position.” It’s when you bet against something that’s publicly traded — a stock, a commodity — by BORROWING it (usually from a broker, for some compensation). You then sell the borrowed asset — at the current price, obviously. And you wait. Wait until the asset DROPS in value, at which point you buy it at the lower price, return the asset to whomever you borrowed it from, and pocket the difference — the difference between what you paid and what you got when you originally sold it. If the price goes UP, of course, you LOSE the difference.
Over time, shorting has come to mean betting against an asset — any asset. (Going LONG, by contrast, means betting it will go up.) NAKED shorting is betting against an asset when you don’t own any of it. It simply means that you don’t own any of the underlying asset.
There’s a huge debate, however, as to whether or not “naked shorting” can actually have the profound influence on markets that its critics contend.
UPDATED JUNE 4 – 10:50 AM
Paul Solman: The beauty of this page — and the electronic age in general — is that a misleading answer can be promptly corrected. Thanks to three knowledgeable readers for pointing out that a “naked short” generally means you haven’t even BORROWED an asset before selling it. And for providing Dr. Cole with far more extensive answers than I did.
But nudist terminology in finance is actually a matter of some controversy, if not confusion, it turns out.
Yes, strictly speaking, “naked short” means not borrowing what you’ve sold when you go short in a stock, say. But “naked” really means something more general in the risk management world.
My guru on the subject of finance, Boston University professor Zvi Bodie, has often appeared on the page. He explains that what “naked” more generally means — and SHOULD be used to mean — is that you’re SPECULATING, instead of HEDGING, an “exposure.” (Another instance of the nudist vocabulary, I guess.)
Okay, then, what’s “exposure”? It’s when your finances will be affected by a change in market value.
You own 1000 barrels of oil which you haven’t yet sold. Your exposure is 1000 barrels of oil. If the price of oil goes up or down, you make money or lose it. Simple.
You own 100 shares of BP. The stock goes up or down. Your exposure is 100 shares. Still simple.
You buy a December futures contract for 100 shares of BP stock at the current market price for that contract — what the market thinks BP stock will be worth in December. If it’s more than the market price come December, you’ll make money; less, you’ll lose. Your exposure is the difference between the contract price and the price in December.
You wrote a million-dollar insurance contract on BP that pays off if the company defaults on its debts. (That’s a credit default swap.) Your exposure is a million dollars. Still pretty simple.
In the first two cases of financial nudity, you’re “covered.” But in the last two, you’re “naked.” Unless you own (or have borrowed) BP stock, you’re simply making a bet.
The key to “nakedness,” then, is the extent to which you are or aren’t HEDGING an exposure you already have. So if you buy that futures contract while HAVING BP stock, you’re covered. You’re totally covered if the amount to BP stock you own is the same as the amount you trade in the futures market. You’re “naked” to the extent that you’re still exposed — you own something that isn’t hedged, that is.
So unlike pregnancy, you can be a little bit naked — or a lot. And in terms of finance as the experts broadly understand it, you can be “naked short,” Professor Bodie insists, even if you HAVE borrowed the underlying stock. That is, you remain UNHEDGED.