In finance, a short sale is the sale of an asset that the seller does not own. The seller effects such a sale by borrowing the asset in order to deliver it to the buyer. Subsequently, the resulting short position is “covered” when the seller repurchases the asset in a market transaction and delivers the purchased asset to the lender to replace the quantity initially borrowed. In the event of an interim price decline, the short seller will profit, since the cost ofpurchase will be less than the proceeds received upon the initial sale. Conversely, the short position will result in a loss if the price of a shorted instrument rises prior to repurchase.
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.
Explaining ‘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.
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.
Naked Shorting FAQ
Can short selling be banned?
Is shorting penny stocks illegal?
Is short selling legal in US?
Why banning short selling is a bad idea?
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- Short selling, death spiral convertibles, and the profitability of stock manipulation – papers.ssrn.com [PDF]
- Naked short selling: The emperors new clothes? – www.econstor.eu [PDF]
- The Naked Truth: Examining Prevailing Practices in Short Sales and the Resultant Voter Disenfranchisement – jot.pm-research.com [PDF]
- The efficacy of Regulation SHO in resolving naked shorts – www.emerald.com [PDF]
- The business ethics of short selling and naked short selling – link.springer.com [PDF]
- The skinny on the 2008 naked short-sale restrictions – www.sciencedirect.com [PDF]
- Predictors of naked short selling: analyzing delivery failures in US stock markets – search.proquest.com [PDF]