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This is very interesting..got it from talkstock..I didnt know some of this stuff, especially the part where you can naked short a BB stock in Canada..a nice read below:
Short Sellers Beware: The End Is Near
February 04, 2004
Sweeping changes are taking place in the world of short selling. Last month the Securities and Exchange Commission (SEC) approved amendments to NASD Rule 3370 that expanded the scope of the affirmative determination requirement to include orders received from non-member brokers and dealers. What this means is that naked shorting may cease to exist on the scale that it currently enjoys. All of this may seem vague and unimportant for most of our readers. You might be thinking what's the big deal because shorting is not something that pertains to your trading or investing strategies. After today's edition we think you will change your mind.
What Is Short Selling
Let's begin with the very basics. Short selling is the selling of a stock that the seller doesn't own but promises to be delivered. A short seller typically borrows stock from a broker to sell it into the market, betting that the share price will fall so that the shorter can buy the stock back at a lower price. Selling short is the opposite of going long.
When you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later you must "close" the short position by buying back the same number of shares (called "covering") and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.
Most of the time, you can hold a short for as long as you want. However, you can be forced to cover if the lender wants back the stock you borrowed. Brokerages can't sell what they don't have, and so yours will either have to come up with new shares to borrow, or you'll have to cover. This is known as being "called away." It doesn't happen often, but is possible if many investors are selling a particular security short.
Since you don't own the stock (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you'll owe twice the number of shares at half the price.
Since you are being loaned the stock, you are buying on margin. In fact, you have to open a margin account to short stocks. Your broker will charge you interest on the loan and you are subject to rules of margin trading. This all sounds easy enough but keep in mind that most U.S. brokerage firms will only allow shorting of stocks that are above $5.00 per share because most brokerages will not allow margin on any stocks under this amount. Thus, it is widely assumed by retail investors that stocks under $5.00 and bulletin board stocks are not shortable. This is true for most people but there is a large loophole in the system.
The Loophole
Until the recent amendment, non-NASD members, like specialists, option markets and foreign brokers, weren't covered under the affirmative determination rule. This rule requires that no member or person associated with a member shall effect a "short" sale order for any customer in any security unless the member or person associated with a member makes an affirmative determination that the member will receive delivery of the security from the customer or that the member can borrow the security on behalf of the customer by settlement date. Non-NASD members didn't have to represent to the NASD broker through which they conducted a short sale order that they would be able to deliver the stock by settlement date.
It's often impossible to borrow the shares of companies trading on the OTCBB so investors and hedge funds looking to take negative bets on these stocks have traditionally been trading through Canada where it's not required to borrow stock before selling it short. The practice is known as naked shorting.
Naked shorting has caused some serious problems for companies trading on the bulletin board. It is a slippery slope that may eventually destroy a company's ability to raise capital. Take a scenario where a scrupulous hedge fund or short selling group decides to naked short a bulletin board company into oblivion. Since no shares have to be delivered, shorts may "hit the bid" until the stock hits zero. Perception is reality so shareholders will see the decline and naturally think that something is wrong and liquidate their positions causing a downward spiral. The shorted company will then be unable to raise any capital because their stock is worthless due to the shorts and not because of fundamentals.
Have you ever owned a bulletin board company or any stock under $5.00? Then you may have experienced shares of your company beaten down by shorts and not even know it.
Conclusion
We applaud regulators for amending the affirmative determination rule. The new NASD rule makes it the responsibility of U.S. brokers trading with non-members to make sure that their counterparts will be able to settle a transaction before completing a short sale. This should dramatically reduce the "naked shorting" that is occurring in the sub $5.00 and bulletin board world.
Short Sellers Beware: The End Is Near
February 04, 2004
Sweeping changes are taking place in the world of short selling. Last month the Securities and Exchange Commission (SEC) approved amendments to NASD Rule 3370 that expanded the scope of the affirmative determination requirement to include orders received from non-member brokers and dealers. What this means is that naked shorting may cease to exist on the scale that it currently enjoys. All of this may seem vague and unimportant for most of our readers. You might be thinking what's the big deal because shorting is not something that pertains to your trading or investing strategies. After today's edition we think you will change your mind.
What Is Short Selling
Let's begin with the very basics. Short selling is the selling of a stock that the seller doesn't own but promises to be delivered. A short seller typically borrows stock from a broker to sell it into the market, betting that the share price will fall so that the shorter can buy the stock back at a lower price. Selling short is the opposite of going long.
When you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later you must "close" the short position by buying back the same number of shares (called "covering") and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.
Most of the time, you can hold a short for as long as you want. However, you can be forced to cover if the lender wants back the stock you borrowed. Brokerages can't sell what they don't have, and so yours will either have to come up with new shares to borrow, or you'll have to cover. This is known as being "called away." It doesn't happen often, but is possible if many investors are selling a particular security short.
Since you don't own the stock (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you'll owe twice the number of shares at half the price.
Since you are being loaned the stock, you are buying on margin. In fact, you have to open a margin account to short stocks. Your broker will charge you interest on the loan and you are subject to rules of margin trading. This all sounds easy enough but keep in mind that most U.S. brokerage firms will only allow shorting of stocks that are above $5.00 per share because most brokerages will not allow margin on any stocks under this amount. Thus, it is widely assumed by retail investors that stocks under $5.00 and bulletin board stocks are not shortable. This is true for most people but there is a large loophole in the system.
The Loophole
Until the recent amendment, non-NASD members, like specialists, option markets and foreign brokers, weren't covered under the affirmative determination rule. This rule requires that no member or person associated with a member shall effect a "short" sale order for any customer in any security unless the member or person associated with a member makes an affirmative determination that the member will receive delivery of the security from the customer or that the member can borrow the security on behalf of the customer by settlement date. Non-NASD members didn't have to represent to the NASD broker through which they conducted a short sale order that they would be able to deliver the stock by settlement date.
It's often impossible to borrow the shares of companies trading on the OTCBB so investors and hedge funds looking to take negative bets on these stocks have traditionally been trading through Canada where it's not required to borrow stock before selling it short. The practice is known as naked shorting.
Naked shorting has caused some serious problems for companies trading on the bulletin board. It is a slippery slope that may eventually destroy a company's ability to raise capital. Take a scenario where a scrupulous hedge fund or short selling group decides to naked short a bulletin board company into oblivion. Since no shares have to be delivered, shorts may "hit the bid" until the stock hits zero. Perception is reality so shareholders will see the decline and naturally think that something is wrong and liquidate their positions causing a downward spiral. The shorted company will then be unable to raise any capital because their stock is worthless due to the shorts and not because of fundamentals.
Have you ever owned a bulletin board company or any stock under $5.00? Then you may have experienced shares of your company beaten down by shorts and not even know it.
Conclusion
We applaud regulators for amending the affirmative determination rule. The new NASD rule makes it the responsibility of U.S. brokers trading with non-members to make sure that their counterparts will be able to settle a transaction before completing a short sale. This should dramatically reduce the "naked shorting" that is occurring in the sub $5.00 and bulletin board world.