Definition of Naked Shorting
Naked shorting can be defined as a practice in which the traders short sell the shares without determining that whether they exist or not at the time of sell, 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.
When the traders short sell the shares that they do not possess or they do not have the ability to possess the share, then this trading is known as naked shorting. Due to this, the trader runs the risk of selling the security units that do not actually exist unless actual securities can be borrowed before the trade settlement date.
Features of Naked Shorting
Features of Naked Shorting are as under:
- It is a kind of 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.
- In this type of contract, the trader enters into the naked position so that the high borrowing cost can be eliminated by directly buying the required asset/security at the time of fulfilment, i.e. when the asset is required to 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 fulfilment, 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 making the payment against it. Now the seller will transfer the asset to the person with whom the contract was made (known as the buyer) 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 been approved for the margin trading, and hence she cannot borrow the security from his broker. She expected a decline in the stock price such that she can purchase the share at a price before the time of delivery at a low price 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 agency of US federal governments 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
There is an impact on the liquidity of the security if naked shorting is used. This is so because, after the initiation of the buying or selling transaction by the brokers or/and dealers of the stocks that are less liquid or that are not readily available in the market using the practice of naked shorting, other investors at the marketplace also start getting interested in the same security as it becomes easy to get the buyers/ sellers of the security. This leads to an increase in the demand for security and thereby an increase in liquidity.
Benefits of Naked Shorting
Different benefits are mentioned below:
- Increases liquidity in the market- The practice of naked shorting allows the traders to participate in the selling of securities even though they actually do not have the securities. With this, additional investors start getting interested in security; with the participation of the additional traders, the demand and liquidity of the security increases. Thus the practice of naked shorting helps in increasing the liquidity of the relatively illiquid security.
- Helps in reducing time and efforts- For short selling, the trader has to borrow the security or determine that 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 without determining that such shares can be borrowed or not. This leads to postponement of the time and efforts are required at the time of making the transaction to the time when there is a requirement of the actual fulfilment of the order. This helps in reducing time and efforts.
- Reduces cost of borrowing- The practice of naked shorting allows the traders to participate in the selling of securities without actually borrowing the securities. This helps in reducing the borrowing cost associated with the borrowing of the securities before short selling it in the market place.
Thus, naked shorting is a strategy that involves selling an asset that the seller does not own or has not borrowed but will purchase it on a later date so that the delivery of the asset can be made at the date mentioned in the contract. There is a risk that the asset will not be available for sale at the time of fulfilment, resulting in the contract’s failure.
This is a guide to Naked Shorting. Here we also discuss the introduction and how does naked shorting work? Along with benefits and features. You may also have a look at the following articles to learn more –