By and large, short-selling is a perfectly legal way to make money in the stock market, but there are times when it can fall outside the law. It’s an illegal trading practice known as naked short selling that’s been banned by regulators. 

This high-risk maneuver appeals to some investors seeking outsized profits without taking proper precautions, but the consequences can be severe.

In this guide, we’ll break down how naked short selling works so you know how to steer clear of it and trade safely.

Understanding Naked Short Selling

Before diving into naked short selling, it’s important to understand how standard short selling works. When an investor believes a stock’s price will fall, they might initiate a short sale. To do this legally, they borrow the shares from a broker and sell them on the open market.

If the price drops, the investor repurchases the shares at a lower price, returns them to the broker, and earns the difference in profit. If the price rises instead, the investor has to buy the shares back at a higher cost, taking a loss.

Naked short sellers skip the borrowing step entirely. By taking advantage of discrepancies between paper and electronic trading systems, as well as regulatory loopholes,they may sell shares they haven’t borrowed (or that may not even exist) leaving the position uncovered. 

Under pressure to close, the investor might then fail to deliver the shares to the broker, resulting in a failed trade. A key red flag is when a trade fails to settle within the standard time frame. While the tactic can be profitable in the short term, it has long-term consequences.

Why is Naked Short Selling Illegal?

To legally short a stock, investors must first locate and borrow the shares. In naked short selling, they skip that step and can’t prove ownership.

The practice creates a problem as the shares being sold may not exist at all. As a result, trades can fail to settle, undermining liquidity and investor trust.

Naked short selling can artificially drive prices lower, which may cause existing shareholders to panic and sell at a loss. By allowing trading without ownership, it can distort market dynamics and mislead investors about true supply and demand.

The U.S. Securities and Exchange Commission (SEC) banned naked short selling after the 2008 financial crisis due to an increase in “failure to deliver” (FTD) transactions. FTDs can lead to stock price manipulation, with sellers driving down prices without owning the underlying shares.

Identifying Naked Shorting

The SEC publishes a list of securities with persistent FTDs which may be subject to naked shorting. When shares consistently fail to be delivered within the required time frame, it can be a sign of trouble.

Safeguarding Market Integrity

Naked short selling results in failed trades and manipulative price action. It poses serious risks to investors and the integrity of the broader market.

Instead, traders should focus on legal, transparent strategies that promote fairness and market stability.

Compare the Best Short Selling Brokers

To practice legal short selling, investors need to choose a regulated broker. Benzinga provides insight into the best short-selling brokers that ensure you engage in safe trading.

Frequently Asked Questions