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Analytics, 02 February 2023

What is Naked Short Selling?

Naked short selling (also known as naked shorting) is the practice of selling short a stock or other tradeable security without first borrowing the shares/ asset to sell or arranging to borrow them. Short selling is used to take advantage of perceived arbitrage opportunities or to anticipate a price fall. Its greatest downside is it exposes the seller to the risk of a price rise.

When the seller does not obtain the asset and deliver it to the buyer within the agreed time frame, this is called a “failure to deliver” (FTD). In ordinary short selling, a trader who wishes to sell short a stock borrows the shares if they are pre-approved for margin trading. When the trader purchases back the shares after the anticipated price drop, they can pay back the shares they had borrowed.

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.

Ordinary vs Naked Short Selling

To understand how naked short selling works, it’s essential to first understand ordinary short selling. When shorting a stock, a trader borrows shares of a certain stock, then sells the borrowed shares to an investor hoping the share price of the stock will fall so that they can buy the shares back on the open market at a lower price and pocket the difference. Naked short selling differs from normal short selling in that:

Effects Of Naked Short Selling On The Market

Market Regulations

Most (but not all) international exchanges have either restricted the practice or implemented server measures to safeguard the market. In August 2011, France, Italy, Spain, Belgium, and South Korea temporally banned all short selling in their financial stocks, while Germany pushed for a euro zone-wide ban on naked short selling.

Investor’s Note

Not all jurisdictions have banned naked shorting and some may argue that it is not necessarily harmful as it can help with determining the true value of a stock in the marketplace when the stock has low liquidity, that is if a limited number of shares are made available for borrowing to be sold short. The best advice to give in cases of naked shorting is to go forward with caution. However, if you are truly convinced that a stock price is about to drop, then shorting can be profitable as long as you stay well-informed.

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