Defining Naked Shorting in Simple Words

The basic type of short selling is selling a stock that you borrowed from an owner, but don’t own it yourself. Fundamentally, you end up delivering borrowed shares. Another type is selling those stocks that neither you own nor you have borrowed from somebody else.

Here, you owe the shorted shares to a buyer but Fail to deliver the same. This type is known as naked short selling. Interested to understand the concept better and deeply? You’ve stumbled upon the right page. This post will help you find out more about naked shorting. Have a read ahead.

What is Naked Shorting

Also known as naked short selling, naked shorting is referred to a system of short-selling a tradable asset of any type without borrowing the security first or making sure that the security is eligible enough to be bought, as it is done conventionally in a short sale.

Normally, traders have to borrow a stock or comprehend that it can be borrowed before it can be sold short. Thus, naked shorting is the short pressure on a specific stock that might be bigger than the tradable shares.

When the seller fails to acquire the shares in the needed time frame, the result is called Failure to Deliver (FTD). Generally, the transaction stays open until the seller obtains shares or the broker of the seller settles down the trade.

Basically, short selling is used to predict a fall in the price. However, it makes the seller exposed to an increase in the price. Back in 2008, abusive naked short selling got banned in America and other jurisdictions.

Under specific situations, failing to deliver shares is deemed legal; thus, naked short selling is, intrinsically, not illegal. Even in America, this practice is covered by a variety of regulations posed by the Securities and Exchange Commission (SEC), which eventually forbids this practice.

However, a lot of critics from around the world have supported stricter rules and regulations for naked short selling.

Explaining Naked Shorting

Put simply; naked shorting generally takes place when investors sell shorts linked with shares that they don’t own and neither they have confirmed the possibility of owning any. If the trade linked to the short has to take place to fulfil the responsibilities of the position, the trade might fail to get completed in the needed clearing time as the seller wouldn’t have any access to the shares.

This certain technique comes with high levels of risks. However, at the same time, it also has enough potential to generate more than satisfactory rewards. Although there is no precise measurement system in place, there are several systems that point to such trade levels that fail to deliver to the buyer from the seller within the necessary three-day stock settlement period as proof of naked shorting. Furthermore, naked shorts are also believed to signify a substantial part of failed trades.

Effects of Naked Shorting

Naked shorting can impact the liquidity of specific security in the marketplace. When a certain share isn’t available readily, naked short selling enables a person to step in, despite their inability to acquire a share.

Suppose more investors show their interest in the shares linked to the shorting. In that case, this can lead to increased liquidity associated with the shares as the demand in a marketplace will eventually increase.

Naked Shorting and the Market Function

Some of the analysts signal to the fact that naked shorting, unintentionally, may help the Market maintain the balance by enabling the reflection of negative sentiment in specific stocks’ prices. If a stock comes with a restricted Float and huge amounts of shares in friendly hands, the signals of the market can hypothetically be delayed and that too unavoidably.

Naked shorting compels a price decrease despite the shares not being available, which can turn into unloading of the real shares to cut losses, letting the market find an adequate balance.

The Naked Shorting Extent

For several years, the naked shorting reasons and extent have been the dispute until SEC prohibited this practice in 2008. What is basically documented is that naked shorting has to happen when there is a difficulty in borrowing shares.

A lot of studies have also signified that naked short selling even increases with the cost of borrowing. In the last few years, a variety of companies had to deal with the accusation of using naked shorts aggressively to drive the prices of shares down, sometimes with no such intention or willingness of delivering shares.

These claims, basically, argue that the practice enables an infinite number of shares to get sold short, at least in theory. Moreover, the SEC also stated that sometimes, this practice had been falsely proclaimed as a reason for the decline in share price when, often, the decrease is because of the poor financial situation of the company instead of the reasons offered by promoters or insiders.