Naked short selling occurs when a trader seeks to make a profit from an expected fall in the price of an asset by selling shares he or she does not own without borrowing, or making arrangements to borrow them. In several jurisdictions this practice is illegal.
Naked short selling has been illegal in the US since 2008.
Its aim is to buy back the security at a lower price than what it was sold for, and making a gain on the difference.
Naked short selling is often illegal because it allows people to manipulate stock prices without taking into account supply and demand.
Normally traders have to borrow a stock, or guarantee that it can be borrowed, before short selling it. However, because of loopholes in rules and discrepancies between electronic and paper trading systems, naked shorting happens on a rather regular basis.
If a trader does not borrow a security before the clearing time period and fails to tender shares to the buyer, the trade has “failed to deliver”. However, the trade continues to sit open until the seller either borrows the shares or closes the position.
“In a ‘naked’ short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period. As a result, the seller fails to deliver securities to the buyer when delivery is due; this is known as a ‘failure to deliver’ or ‘fail’.”
Video – Should naked short selling be banned?