What Is Naked Short Selling, How Does It Work, and Is It Legal?

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. So naked shorting refers to short pressure on a stock that may be larger than the tradable shares in the market.

Despite being made illegal after the 2008–09 financial crisis, naked shorting continues to happen because of loopholes in rules and discrepancies between paper and electronic trading systems.

Understanding Naked Shorting

Naked shorting takes place when investors sell 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, then the trade may fail to complete within the required clearing time because the seller does not actually have access to the shares. The technique has a very high risk level but has the potential to yield high rewards.

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

The Impact of Naked Shorting

Naked shorting can affect the liquidity of a particular security within the marketplace. When a particular share is not readily available, naked short selling allows a person to participate 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.

Regulations Regarding Naked Shorting

The Securities and Exchange Commission (SEC) banned the practice of naked short selling in the United States in 2008 after the financial crisis. The ban applies to naked shorting only and not to other short-selling activities.

Prior to this ban, the SEC amended Regulation SHO to limit possibilities for naked shorting by removing loopholes that existed for some brokers and dealers in 2007. Regulation SHO requires lists to be published that track stocks with unusually high trends in failing to deliver (FTD) shares.

Naked Shorting as a Market Function

Some analysts point to the fact that naked shorting inadvertently might help markets stay in balance by allowing the negative sentiment to be reflected in certain stocks' prices. If a stock has a limited float and a large number of shares in friendly hands, then market signals can theoretically be delayed inevitably. Naked shorting forces a price drop even if shares aren't available, which can, in turn, result in some unloading of the actual shares to cut losses, allowing the market to find the right balance.

Examples of Naked Shorting

Per SEC regulations, participants in naked short selling activities can be charged with a crime. In fact, in 2014, two Florida State University professors were charged with using a naked short selling strategy in more than 20 companies to earn more than $400,000 in revenue. In 2018, there was widespread speculation that naked shorting was endemic in the cannabis sector as shares were highly sought after and thus limited, but short interest continued to grow regardless.