What is Naked Short Selling?

How does naked short selling impact markets, and why is it so controversial? 

Naked short selling lets traders sell shares they haven’t borrowed or secured, unlike traditional short selling. While it offers unique opportunities, it also raises risks of market manipulation and instability. Its impact on stock prices, liquidity, and volatility makes it essential for traders and regulators to understand.

This article will break down what naked short selling is, how it works, and why it continues to spark debate in the financial world.

Defining Naked Short Selling 

It is a trading practice where one sells a stock without first borrowing the stock or having a reasonable expectation of borrowing the stock first, before selling the stock. Traditional short selling requires that a trader borrow shares from a broker and then sell them on the open market in the hope of purchasing them back at a discount to pay back the lender, but this permits traders to short stocks without needing to borrow shares.

A naked short sale occurs when the seller has neither borrowed nor secured the shares at the time of the sale and is selling something he doesn’t have and may not be able to deliver to the buyer on settlement time.

The difference between naked short selling and traditional short selling is that, in the latter, the seller must borrow shares before selling. With traditional short selling you actually borrow the shares so you have to know where they are. Today, naked shorting circumvents this process, and risks adding to the probability that there will not be enough shares available to ‘cover’ the short on the day it is due to settle.

Due to these factors, naked short selling is a factor in excess market volatility and distorted stock prices. However, the practice is controlled in many markets, especially on low liquidity stocks, not enough shares to artificially spike prices.

Traders may still engage in naked short selling to profit from short-term price swings, despite its risks. Counter to regulatory restrictions, it remains a questionable practice, its legality and ethical implications, as well as market impacts, continue to be debated.  

Mechanics of Naked Short Selling 

In naked short selling, traders sell shares they neither own nor have borrowed, often without confirming whether the shares can be borrowed. In a traditional short sale, the trader borrows shares from a broker, sells them and commits to having his broker purchase them later.

In naked short selling, traders skip the borrowing step and sell shares that they don’t own. The trade assumes the shares will be available by the settlement date; however, if they are not, it results in a failure to deliver. 

But brokers have a big role in doing the heavy lifting for short selling: they are responsible for going out and finding shares to borrow for traditional short sales. In naked short selling, brokers might not find the shares and still allow the trade, which could result in a failure to deliver by settlement time.

This failure to deliver—or missing shares—makes the market more complex and risky, particularly in low-liquidity stocks. Similar risks can arise with naked options, where sellers do not own the underlying asset, further amplifying the potential for market disruption. 

Naked short selling is limited via regulations so abuse does not occur. It’s banned or tightly regulated in many markets—think the U.S.’s Regulation SHO and its ‘locate rule,’ which requires brokers to find borrowable shares before they sell them short.

Other measures include shared penalties for tardiness in delivery and greater transparency around short selling. Yet in some markets or cases, naked short selling continues on with safeguards notwithstanding, triggering debates about market fairness and stability. 

How Naked Short Selling Impacts Market 

Market liquidity, volatility and overall stability can be affected significantly by naked short selling. It artificially increases share supply by letting traders sell shares they don’t own or have not borrowed.

The most frequent result of naked short selling is driving stock prices lower — especially when the volumes of naked short sales are high. It amplifies price swings in stocks that don’t trade much, making them even more volatile and making the market itself less stable.

Targeting smaller or less liquid stocks can also have one major consequence — market destabilization. When there is large-scale selling that happens without delivery, it leads to ‘failure to deliver’ situations, which break the price discovery process and throw the supply-demand dynamics out of order.

This can artificially inflate stock prices, sometimes triggering a short squeeze, which further distorts the market and creates uncertainty about a stock’s real value. These artificially inflated or depressed prices are not based on market fundamentals, and retail investors and companies can suffer significant losses. 

Naked short selling can weaken investor confidence. When participants suspect manipulation—possibly through unchecked short selling—they may become reluctant to participate in the market, which can contribute to liquidity problems, even in otherwise liquid stocks. While regulatory bodies have addressed these concerns through restrictions on naked short selling and sanctions for failing to deliver, the practice remains controversial.

Advocates argue that it can, in some circumstances, improve liquidity by enabling trades that might not otherwise occur. However, these perceived benefits are typically outweighed by the risks of increased volatility, destabilized prices in weak or low-cap markets, and facilitation of market abuse.

The Process of Executing a Naked Short Sell

A naked short sell occurs when a trader sells stock that they neither have nor have borrowed for them, which is a complex and dangerous manoeuvre. It begins when a trader begins selling shares that the trader thinks will decrease in value.

When an order is placed, a sell order for example, the trade is done as if the shares were available, however, the seller is obligated to deliver the shares by the settlement date, typically two business days after the trade (T+2). When a number of traders do the same thing to the stock, it can drive more downward pressure on the price.

A failure to deliver will occur if the trader cannot obtain the shares by the settlement date. Naked short selling can be penalized by regulators or the broker, since it’s closely watched on concerns that it will destabilize markets. But brokers may step in by arranging for shares to be borrowed into a trader’s account or doing something else to finish the trade. 

Controversy surrounds naked short selling, a practice considered dangerous to investors as it enables a few traders to manipulate the market and exploit available market capital. 

Historical Overview of Naked Short Selling

For as long as they’ve been a trading tactic, naked short selling has drawn regulatory attention, with the tactic receiving periodic attention when markets are volatile. A practice of this sort, which involves the sale of shares without first borrowing them, has been criticized as distorting stock prices and making markets unstable. At one time common, it has been increasingly restricted over the years due to its potential for abuse.

The first efforts to regulate naked short selling, like the practice itself, date back to the early 20th century in the wake of the extreme volatility of the 1929 stock market crash. The SEC was established by the Securities Exchange Act of 1934, which also launched the regulation of short selling. But it wasn’t until the early 2000s that naked short selling came under intense scrutiny, following the dot com bubble and corporate scandals.

Regulation SHO was introduced by the SEC in 2005 to combat abusive naked short selling. The rule forced brokers to “locate” — meaning guarantee that shares are available, so that they can be delivered to settle a trade — before short selling and compelled brokers to quickly close trades that failed in order to prevent prolonged “failure to deliver” situations that could undermine market stability.

Naked short selling has come under the spotlight in the 2008 financial crisis, blamed for lowering stock prices and helping the tumble of major financial institutions. As a response, the SEC imposed temporary bans on short selling for some financial stocks and strengthened enforcement of existing rules. In this era, there were high profile cases and large fines to financial firms over violations.

Today, naked short selling is illegal in most jurisdictions and there are strict regulations, increased transparency to avoid the practice, and penalties should be enforced. Limited though it may be in terms of occurrence, there are ongoing debates over the ethical and economic implications of it in the financial world. 

Legality and Ethical Considerations 

The practice of naked short selling is heavily regulated or even completely banned in many jurisdictions because of its ability to upset markets. It is largely banned in the U.S. thanks to Regulation SHO issued by the SEC that forces brokers to “locate” shares before selling them short to ensure the shares can be borrowed to cover the sale. But this rule blocks traders from posting sell orders they cannot complete, in order to avoid artificially low stock prices and other distortions.

Nevertheless, the SEC has codified these rules, most obviously following a crisis like the 2008 financial crisis when naked short selling was blamed for magnifying the fall of major financial institutions.

In the European Union, transparency requirements and almost all naked short selling has been banned for most of the jurisdictions through the European Short Selling Regulation. Additionally, numerous countries, including Germany and France, have also enacted temporary bans when additional market stress occurs, in order to protect vulnerable stocks. For example, similar restrictions exist in Australia and Canada, in part so as to prevent abuse and maintain market stability.

Even with legal measures, naked short selling is still a debatable ethics topic. They say it’s good because short sellers expose overvalued stocks and help the price to correct. But critics counter that naked short selling manipulating prices down while possessing no liability to provide for share delivery. In the latter case, it can activate panic selling and undermine market integrity, asking if profits justify the risk to fairness and stability. 

Naked vs. Traditional Short Selling 

There are two strategies for profiting from expected stock price declines, naked short selling and traditional short selling, but with very different mechanics and risks. When learning about traditional short selling, traders borrow shares from a broker then sell the shares in the market.

To return to the lender, they later repurchase the shares — ideally at a lower price. This makes sure that the trade was backed by actual shares and makes sure that everything is transparent and stable in the market.

It’s called ‘naked short selling’ because it completely skips the borrowing step. In executing sell orders, these traders do not need to own or borrow those shares, assuming they can get them before settlement date.

That in turn introduces significant risks, given that failure to secure shares can lead to a ‘failure to deliver’, which in turn distorts supply-demand dynamics and depresses the stock price. Naked short selling artificially inflates share supply, destabilizing markets and raising regulatory and ethical concerns.

Traditional short selling, however, is inherently less risky for the broader market because it takes such steps as locating and borrowing shares in advance, which helps to make for a more controlled process. This also allows for short coverings—the process of buying back shares to close a short position—which stabilizes supply-demand dynamics. Traditional short selling is clear and regulated, unlike naked short selling, which is often restricted or banned.

However, naked short selling increases trader risk because it allows for legal consequences since the vendor does not guarantee share delivery. Critics have called the practice loose because it allows manipulation of prices by putting artificial sell pressure on the shares — an activity that doesn’t involve borrowing the shares. 

Although both approaches seek to profit from declined prices, naked short selling, because of the risk of price distortion and loss of confidence, has become a controversial matter. While throughout history it has been used as part of various trades and is still used until now despite its risks and unethical implications. 

Real-World Instances of Naked Short Selling 

Controversially, naked short selling has had a significant impact in a number of high profile market events. It came in for widespread criticism in the 2008 financial crisis, when it was said to have played a part in bringing down firms like Lehman Brothers. Traders employing naked short selling drove down the stock prices of fragile companies even further, exacerbating market instability and creating panic in investors during a wild moment, critics claimed.

To prevent market instability, the U.S. Securities and Exchange Commission (SEC) resolved to ban temporary naked short selling of some financial stocks. To curb short selling and keep it in line with settlement requirements, the SEC also bolstered regulations, such as its ‘Regulation SHO.’ The actions were designed to stop naked short selling abuses and its destabilizing effect.

A more recent controversy is when the GameStop short squeeze occurred in early 2021. While briefcase short sellers were largely the focus of attention, there were worries that naked short selling could be adding to volatility. The event also exposed possible regulatory enforcement gaps and raised issues regarding the transparency and fairness of short selling transactions, in particular naked short selling.

The episodes depict instances in which naked short selling, unchecked, can be used to hijack and disrupt markets. They also illustrate why regulators, market participants continue to argue its function, as they try to discern the risks from the need for fair and efficient market operations. 

Regulatory Framework and Compliance 

Naked short selling regulations have been developed in order to mitigate the systemic risk and manipulation potential of the technique. Regulation SHO (short sales), introduced by the SEC in 2005, was supposed to curb abusive short selling, such as naked short selling in the U.S. A major provision, known as the ‘locate’ rule, requires brokers to first confirm they can borrow or locate shares before effecting a short sale, ensuring a sale cannot be carried out without the shares.

Regulators had already turned up the heat on short selling in the wake of the 2008 financial crisis. As such, the SEC amended Regulation SHO in order to require tighter oversight and decreased failures to deliver, which occurs when a seller is unable to provide the shares sold by the settlement date.

During the crisis, temporary bans on naked short selling for certain financial stocks were also imposed to stabilize markets. To reduce the risks associated with uncontrolled short-selling activities, these efforts were made.

Regulators throughout the world have taken the same measures. Under the EU Short Selling Regulation (SSR) the European Securities and Markets Authority (ESMA) banned naked short selling in 2012, which requires traders to borrow or have agreements to borrow shares before they trade. Just as it has been reported that Australia and Canada have also made short selling regulation stricter to maintain market integrity.

And despite the regulations, enforcement is difficult. Recently, we have seen fines and other penalties imposed on brokers and traders who fail to comply with those rules. The measures offer regulators’ reassurances to effectively prevent mining and trading goals from causing a distortion of markets, to the exclusion of a fair and stable trading environment. 

Advantages and Risks of Naked Short Selling

Short selling naked provides both potential rewards and some significant risks to target making the practice controversial but possibly very profitable. A big plus is that you can benefit from a decreasing stock without taking out loans for shares, making execution work faster and excluding borrowing costs of the usual short selling. This potential for profit is huge, even if shares aren’t immediately available, to traders who accurately predict market downturns and sell high, only to buy back at cheaper prices.

This can also enhance the market liquidity in naked shorting. It does so by letting more people sell shares they don’t own, which leads to higher trading activity, narrower bid-ask spreads and better price discovery — getting markets to reflect securities’ true value more quickly.

The risks are, however, significant. The main danger is that it has unlimited loss potential. But if the shorted stock price rises instead of falls, where is the ceiling, and the traders have to buy to cover at much higher prices—and take big losses. Naked shorting is different from buying stocks, which have built in losses that cannot exceed the money invested, while naked shorting potentially exposes traders to much greater financial liability.

Moreover, naked short selling can contribute to such instability, as can occur in volatile times. It also may exacerbate downward pressure on stock prices, which will harm companies and shake broad market confidence. The regulatory risk is there — naked shorting is banned or tightly regulated in many markets. Any Trader found breaking these rules may be hit with fines or legal action.

In online markets, naked short selling is widely criticized by investors — it could potentially create high returns, but there’s risk for market instability, unlimited losses, and regulatory penalties. Tools like stock alerts can help investors monitor potential risks or market activity related to naked short selling, providing timely insights to support informed decisions. 

Conclusion

Stock trading has a powerful and controversial strategy known as naked short selling. The risks of options include unlimited potential losses and the potential of added pressure on stock prices, making options highly speculative and while they can be an opportunity for profit in declining markets. It is a strategic tool only for traders who comprehend the mechanics and risks, but only, and again, this is provided the legal and financial consequences are also well understood.

Since the enactment of Regulation SHO, other restrictions have been gradually imposed on naked short selling on the belief that the practice can be harmful to market stability. This means traders should be cynical when dealing with binary options as it is a practice that carries with it potential legal penalties that traders need to adhere to so as to avoid getting punished. For most traders ultimately this is still going to be a riskier game to play and traditional short selling or other strategies may be a better risk reward balance. 

Decoding Naked Short Selling: FAQs

How Does Naked Short Selling Affect Stock Prices in the Short Term?

Artificial inflation of supply through the selling of shares without delivery is naked short selling, and it can drive stock prices down in the short term. The smaller, less liquid companies are especially liable to downward pressure, and value erodes steeply. This supply imbalance is exacerbated when panic selling occurs—something often seen during periods of heightened volatility, like the October effect—causing prices to fall even further. 

What Measures Do Exchanges Take To Detect and Prevent Illegal Naked Short Selling?

Short positions are monitored by exchanges and compliance required on delivery can be enforced via buyins, fines, and other rules as in Regulation SHO and its ‘locate rule,’ which requires brokers to confirm shares can be borrowed before selling them short. If shares aren’t delivered in the settlement period, brokers are forced to buy in. They also work with regulators to identify and investigate suspicious trading.

Can Retail Investors Participate in Naked Short Selling, and What Are the Risks?

Naked short selling is so rarely available to retail investors precisely because of the margin and borrowing requirements brokers place on them. Typically, retail traders are required to locate or borrow shares first before trading them short. There are risks of unlimited losses if stock prices go up, forced buy-ins if delivery of shares can’t be made, margin calls when account balances fall below required levels, and regulatory scrutiny. Stock trade alerts are tools that help retail investors monitor market activity and reduce risks. 

How Do Regulatory Bodies Enforce Penalties for Illegal Naked Short Selling Practices?

The SEC and other regulators impose fines, sanctions, and, in some cases, criminal penalties for illegal naked short selling. They look at failure-to-deliver (FTD) reports and investigate the possibility of manipulation. Repeat offenders face significant fines, bans or suspensions from trading to maintain a compliant and orderly market.

What Are the Ethical Considerations Associated with Naked Short Selling?

Naked short selling has been criticized because it is an unethical act that can let speculators manipulate stock prices, hurt companies and investors. Such excessive or illegal use can put unfair downward pressure on company valuations and give investors a loss of confidence. Its detractors claim it distorts supply demand dynamics—destroying the integrity of the market—while those in favor say that a legal short selling improves liquidity and corrects overvalued stocks.