Wednesday, September 30, 2009

Why Naked Shorting Isn't Really That Different From Regular Short Selling: The Two Cows Version

Posted on the Business Insider by John Carney:

Still confused about why you shouldn't be worked up over naked short selling? We understand. It's terribly complex and full of words that make your eyes glaze over.

So we decided to break it down into the simplest terms Wall Street transactions can be explained: the two cows

story.

This is a simplification, since it leaves out the role of a clearing house. But that's the point: to simplify a very complicated process.

Traditional Short Selling: Two Cows

You neighbor Joe has two cows.

You borrow the cows.

You sell two cows your other neighbor Henry.

Henry agrees to pay you $100 for each cow.

At this point, you are net short two cows. You have the two you borrowed from Joe but you owe a total of four: two to Henry and two to Joe.

You go out into the market and look for more cows so you can give Joe his two cows back.

You hope the price is less than $100 per cow.

If the price of cows drops to $80, you just made $20 on each cow. If it climbs to $120, you lost the same amount on each cow.

Either way you close out the trade by delivering cows to Henry, collecting the money for delivery, and buying Joe the replacement cows.

Naked Short Selling: Two Cows

Your neighbor Joe has two cows.

You don’t borrow them.

You sell two cows to your neighbor Henry with a promise to deliver them in a few days.

Henry agrees to pay you $100 for each cow.

At this point, you are net short two cows. You don't have any cows but you owe a total of two: both of them to Henry.

You go out into the market and look for more cows so you can deliver two cows to Henry.

You hope the price is less than $100 per cow.

If the price of cows drops to $80, you just made $20 on each cow. If it climbs to $120, you lost the same amount on each cow.

You close out the trade by delivering cows to Henry and collecting the money for delivery.

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