Short selling had been a staple technique for investors who try to hedge against declining markets. It involves borrowing stocks from a broker to sell them at their current price, then buying them back at a lower price. However, there had been cases wherein investors do not actually possess the stocks before shorting them. This technique is called naked short selling, which would be explained in this article.
What is naked short selling?
Naked short selling or naked shorting, is the method of short selling a security without borrowing it first from a broker. This method is already banned in most countries, as it results in a failure in delivering the shares paid by buyers. It is also known to have contributed to previous financial crises by forcing stock prices to go down through stock manipulation.
Naked short selling vs. Short selling
The usual short selling method involves borrowing a company’s stock and selling it in speculation that the stock’s value will decline. Once the stock price declines, the short seller buys the same number of stocks at a lower price to cover the original borrowed stocks. The diagram below shows the correct process of short selling.
On the other hand, naked short selling starts by selling stocks that are neither borrowed, nor ensured the capacity to deliver the stocks being sold. A buyer accepts the trade, but does not receive the stocks agreed upon. When the seller does not obtain the shares within the allotted time frame, it results in what we call a “fail to deliver”. However, the transaction generally remains open until the shares are acquired by the seller or the broker of the seller settles the order. Naked shorting is similar to the process of short selling, minus the part where the broker and short seller interacts.
Effects of naked short selling
Naked short selling can affect the liquidity of the securities involved. If the supply of the security is not readily available for trade, naked shorting allows people to participate with the trade without actually possessing the share. If more investors become interested in the same security, this could result in an increase in liquidity and demand for an asset with a very limited supply.
It is safe to say that naked short selling generally contributes to fake price fluctuations through stock manipulation. It also results to unsettled transactions in the market that causes further problems as both parties need to find a solution to obtain the shares in order to close the trade.
Because of these, numerous countries had banned naked short selling in their markets. It is also believed that the controversial method had contributed to some economic declines in the past years. However, due to various loopholes in trading systems, naked short selling continues to happen despite the strict warning of governing bodies to active investors.
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