September 7, 2008
Naked short selling does not compensate the actual owners of stocks for the dilution in price that occurs by the artificial expansion of shares in the market.
The number of shares available for trading is artificially increased by the selling of electronically conceived shares that actually do not exist into the market. Economics dictates that the larger the number of shares available (the greater the supply) the lower price (cost) per share for any given level of demand. This is a natural advantage of naked short selling naked short sellers are guaranteed to make money by diluting the number of shares available for trading. Conceivably, any share price can be driven to zero if one only needs to expand the quantity of electronically generated fictitious shares available a flood of fictitious shares could conceivably dilute any stocks share price to zero.
To date, no rules have been implemented to compensate for this natural dilution effect. This requires regulatory action to either ban short selling, or compensate by adding additional cost for negated short selling for this dilution effect. Compensating for this cost could be done by calculating the effect of the dilution and rounding up to the nearest cent for each share of stock in a naked short.
For example, assume the total number of shares in XYZ stock available not including naked shorts is 1000 shares. If someone naked shorts 100 shares, then the dilution effect per share of existing stock would be
P/1000 - P/1100 = D
Where
P is the price at which the shares are naked shorted, and
D is the calculated natural dilution in price per share due to dilution rounded up to the nearest cent.
This compensation for a natural advantage in diluting a stock as the result of naked short would be rounded up to the nearest cent per share and charged at the time of the naked short and would act to compensated for this natural advantage. These funds could then be returned to the company, XYZ to be included as dividend or could be collected by the regulator agency for administering the compensation, or a combination of both.
This action would take away any natural advantage in short selling to make the transaction fair form a pricing stand point. The only other way to take away the natural disadvantage would be to ban naked short selling all together one or the other needs to be done to stop this abuse.