What is Naked Short Selling?

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Contributor, Benzinga
October 17, 2022

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Short selling is legal if an investor has borrowed stocks first. Without borrowing stocks, investors who short them are engaged in an illegal practice of naked short selling. This type of trading may be alluring to investors wanting to profit without taking risks, but its consequences are severe.

Investors should avoid engaging in naked short selling and should know how to spot securities that have not been determined to exist. Benzinga provides a guide about naked short selling to help investors increase their chances of engaging in safe and legal trading.

What is Naked Short Selling?

To understand naked short selling, investors need to know how short selling works. Investors who believe a share’s value will decrease can profit by opening a sell position. Since investors don’t own shares when selling them, they need to borrow them from a broker. 

After borrowing shares from a broker, the investor sells them on the open market. Once the share’s value decreases, the investor buys them and returns the borrowed shares to the broker. If the buying price is lower than the selling price, the investor profits from the difference. Closing a short-sell position with a higher buying price than the selling one results in the investor incurring a loss of the difference.

Investors engaged in naked shorting don’t borrow shares before selling them. They sell shares they don’t own or aren’t confirmed to exist. Shares that are unavailable to cover a short position are exposed to being naked. A seller under pressure to close a position may fail to deliver shares to the broker because they weren’t borrowed. The discrepancies between paper and electronic trading systems and loopholes in trading rules facilitate naked short selling.

Indications of naked short selling are usually when a trade isn’t delivered from the seller to the buyer within the obligated settlement period. This trading strategy is highly risky but can provide investors with large profits. It can also negatively impact the liquidity of a certain stock in the market. 

What is a Margin Account?

Investors wanting to increase the size of their positions can use a margin account. It’s a brokerage account that lends traders cash to buy securities. The broker uses the purchased securities and cash to collateralize the loan.

Margin trading increases the investor’s purchasing power because of the borrowed money. That enables the investor to lock in larger profits or suffer higher losses. Some brokers offer margin accounts with periodic interest rates.

Using a margin account is best suited for expert traders who know how to manage risk and possess a high level of understanding of this strategy.

Why is Naked Short Selling Illegal?

The legal practice of selling shares requires investors to borrow them before opening a short position. In naked short selling, investors don’t borrow shares. They cannot prove they own the shares they shorted, and naked short shares may not be determined to exist.

Naked short selling has resulted in numerous failed trades because naked short sellers cannot take ownership of shares they never borrowed. The U.S. Securities and Exchange Commission (SEC) banned naked short selling after the 2008 global financial crisis.

The key reason for the ban was because of the growing trend of failure to deliver (FTD) shares. The SEC removed loopholes in Regulation SHO to prevent brokers from enabling naked short selling. Another risk of FTD on the settlement date is the possibility of stock price manipulation.

Identifying Naked Shorting

One way of identifying naked shorting is by following the lists SEC requires to be published of securities that result in high volumes of FTD. Investors should watch out for shares identified as regularly failing to deliver from the seller to the buyer within the required settlement period.

How Does Naked Shorting Impact the Market?

Naked short selling can artificially decrease a stock’s price, despite shares not being available. Investors who own the share can become jittery because of the falling price, prompting them to sell their shares to avoid losses.

Since naked short selling enables investors to participate without owning shares, liquidity can increase if the demand for the shares increases. Large FTD shares can deprive shareholders of ownership rights.

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.

  • Cobra Trading
    More Details
    Best For
    Short Selling over $25K
    Overall Rating
    Read Review
    securely through Cobra Trading's website
    More Details
  • CenterPoint Securities
    More Details
    Best For
    Momentum traders
    Overall Rating
    Read Review
    securely through CenterPoint Securities's website
    More Details
  • TradeZero
    More Details
    Best For
    Overall Global Broker for Short Selling
    Overall Rating
    Read Review
    securely through TradeZero's website
    More Details
  • IBKR ETF
    More Details
    Best For
    Active and Global Traders
    Overall Rating
    Read Review
    securely through IBKR ETF's website
    More Details

Frequently Asked Questions

Q

Is naked short selling a crime?

A

The U.S. SEC has banned naked short selling. It’s considered an illegal trading practice, and participants can be fined or charged with a crime.

Q

How do you know if someone is naked short selling?

A

Naked short sellers may fail to deliver shares when they close a short position because they didn’t borrow them.