What is 'Naked Shorting'

Naked shorting is the illegal practice of short selling shares that have not been affirmatively determined to exist. Ordinarily, traders must borrow a stock, or determine that it can be borrowed, before they sell it short. Due to various loopholes in the rules, and discrepancies between paper and electronic trading systems, naked shorting continues to happen.

BREAKING DOWN 'Naked Shorting'

With naked shorting, an investor sells shorts associated with shares that they do not possess and have not confirmed their ability to possess. If the trade associated with the short needs to take place in order to fulfill the obligations of the position, the trade may fail to complete within the required clearing time because the seller does not actually have access to the share. The technique is seen as very high risk, regardless of its associated legal entanglements, but has the potential to yield high rewards.

While no exact system of measurement exists, most systems point to the level of trades that fail to deliver from the seller to the buyer within the mandatory three-day stock settlement period as evidence of naked shorting. Naked shorts may represent a major portion of these failed trades.

Naked Shorting and Liquidity

Naked shorting can affect the liquidity of a particular security within the marketplace. In cases in which a particular share is not readily available, naked short selling allows a person to participate within the associated activity even though they are unable to actually obtain a share. If additional investors become interested in the shares associated with the shorting, this can cause an increase in liquidity associated with the shares as demand within the marketplace increases.

Regulation Regarding Naked Shorting

The practice of naked short selling was banned within the United States in 2008 after the financial crisis of 2007/2008, as such activities contributed to the downward economic trend by allowing manipulators a chance to force stock prices down without regard for normal stock supply/demand patterns. The ban applies to naked shorting only and not to other short-selling activities.

In 2007, the Securities and Exchange Commission (SEC) amended Regulation SHO to further limit possibilities for naked shorting by removing loopholes that existed for some broker/dealers. Regulation SHO requires lists to be published that track stocks with unusually high trends in "fail to deliver" shares. Some analysts point to the fact that naked shorting, albeit inadvertently, may help markets stay in balance by allowing the negative sentiment to be reflected in certain stocks' prices.

Participants in naked illegal short selling activities can be charged with a crime based on the SEC regulations. In 2014, two Florida State University professors were charged with participating in the illegal practice that resulted in approximately $400,000 in revenue. Ultimately, the accused agreed to a settlement with the SEC in the amount of $670,000.

  1. Naked Option

    A naked option is created when the seller of an option contract ...
  2. Naked Position

    A securities position that is not hedged from market risk. Both ...
  3. Naked Put

    A naked put is an options strategy in which the investor writes ...
  4. Custody-Only Trading

    A system in which shares must be registered to the holder by ...
  5. Sell To Open

    A phrase used by many brokerages to represent the opening of ...
  6. Short Selling

    Short selling is the sale of a security that is not owned by ...
Related Articles
  1. Trading

    Naked Options Expose You To Risk

    Find out why these enticing options can spell trouble for your bottom line.
  2. Personal Finance

    Short Selling: Making The Ban

    Short selling has been around as long as the stock market, and it hasn't always been looked on favorably.
  3. Trading

    Why is Short Selling Legal? A Brief History

    Short selling -- selling borrowed stock in hopes the price goes down --used to be unregulated.
  4. Investing

    Europe Bans Short Selling

    Regulators in Europe have taken temporary emergency action and banned the short selling financial companies. Find out more.
  5. Investing

    Why Short Sales Are Not For Sissies

    Short selling has a number of risks that make it highly unsuitable for the novice investor.
  6. Trading

    The Short Squeeze Method

    The short squeezed strategy can be risky - but also very rewarding - for those who master it.
  7. Investing

    Using Short ETFs to Battle a Down Market

    Instead of selling your stocks to get gains, consider a short selling strategy, specifically one that uses short ETFs that help manage the risk.
  1. Why Is Short Selling Illegal in Some Countries?

    Discover why many countries banned the practice of short selling financial stocks—but not the US. Read Answer >>
  2. How is a short call used in a naked call writing option strategy?

    Learn how a short call is used in a naked call writing strategy, and understand the high degree of risk associated with this ... Read Answer >>
  3. What is the difference between a covered call and a regular call?

    Learn what a call option is, what two strategies call options can be used for, and the difference between a covered call ... Read Answer >>
  4. What is the difference between a short squeeze and short covering?

    Learn about short covering and short squeezes, the difference them and what causes short squeezes. Read Answer >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Liquidity

    Liquidity is the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's ...
  3. Federal Funds Rate

    The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve ...
  4. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  5. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  6. Entrepreneur

    An entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture.
Trading Center