Updated July 14, 2023
Definition of Naked Shorting
Naked shorting can be defined as a practice in which the traders short sell the shares without determining whether they exist or not at the time of sale, i.e., in other words, it is the short sell of the shares without borrowing the stock or without determining that such shares can be borrowed or not.
Traders engage in naked shorting when they sell shares they do not possess or cannot possess. Due to this, the trader risks selling the security units that do not exist unless actual securities can be borrowed before the trade settlement date.
Features of Naked Shorting
- It is a practice that involves short-selling the share or securities without actually borrowing it or ensuring that the stock can be borrowed.
- It aims to generate liquidity for a thinly traded stock where the number of available units is very less.
- The trader enters into the naked position in this type of contract to eliminate the high borrowing cost by directly buying the required asset/security at the time of fulfillment, i.e., when the asset must be delivered.
- The concept of naked shorting is riskier than short selling as there is a risk that the asset might not be available at the time of fulfillment, and as a result, the contract may fail.
How Does Naked Shorting Work?
In naked shorting, the seller/trader enters into the contract of delivering the share/security at a pre-determined date and specified price to the buyer. The seller expects that the asset’s price will fall in the near future, so he enters into the contract to sell the asset at a higher price. Then at the time of delivery or before delivery, the seller purchases the asset from the market by paying against it.
Now, the seller will transfer the asset to the buyer, the person with whom the contract was made, at the determined date and price. If the seller’s expectation that the predetermined price will be higher than the price at which the seller has purchased the asset is met, then the difference between the contract price and the price at which the seller has purchased the asset is the profit for the seller.
Example of Naked Shorting
For example, Mrs. Eden enters into the contract of short-selling 50 shares of ABC Incorporation. At the time of the contract, Mrs. Eden was not holding the security and was also not approved for margin trading. Hence she could not borrow the security from his broker. She expected a decline in the stock price to purchase the share at a low price before delivery compared to the contract price. The difference between the purchase cost of the share of Mrs. Eden and the contract price will come out to be the profit of Mrs. Eden.
Regulations of Naked Shorting
After the 2008 financial crisis in the US, the Securities & exchange commission (SEC) banned the naked shorting practice in the country where the SEC is one of the independent agencies of the US federal government responsible for implementing the federal securities laws in the country and proposing the securities rules. This ban is restricted only to the naked shorting.
Effects of Naked Shorting
Naked shorting usage impacts the liquidity of the security. After brokers or dealers initiate buying or selling transactions of less liquid or unavailable stocks using naked shorting, other market investors become interested in the same security due to the increased ease of finding buyers or sellers. This leads to increased demand for security and, thereby, liquidity.
Benefits of Naked Shorting
- Increases liquidity in the market – The practice allows traders to participate in selling securities even though they do not have the securities. With this, additional investors start getting interested in security; with the additional traders’ participation, the security’s demand and liquidity increase. Thus, it helps increase the liquidity of the relatively illiquid security.
- Helps in reducing time and effort – For short selling, the trader has to borrow the security or determine whether it is possible to borrow the security or not. However, the practice of naked allows the traders to short-sell the securities without borrowing the stock or determining whether such shares can be borrowed. This leads to postponement of the time and effort required when making the transaction to when there is a requirement for the actual fulfillment of the order. This helps in reducing time and effort.
- Reduces cost of borrowing – The practice of naked shorting allows traders to participate in selling securities without actually borrowing the securities. This helps reduce the borrowing cost associated with the securities before short-selling them in the marketplace.
Thus, naked shorting is a strategy that involves selling an asset that the seller does not own or has not borrowed but will purchase at a later date to deliver the asset at the date mentioned in the contract. There is a risk that the asset will not be available for sale at the time of fulfillment, resulting in the contract’s failure.
This is a guide to Naked Shorting. Here we discuss the introduction and how naked shorting work, along with benefits and features. You may also have a look at the following articles to learn more –