Naked shorting is an investment tactic that involves short selling securities that the seller may or may not have permission to use in the investment deal. In this scenario, the investor executes an order to sell the securities short, without necessarily owning the shares or having permission to borrow those shares for purposes of creating a short sell. This can lead to situations where failed trades are created, and buyers lose both time and money as a result. In many areas around the world, naked shorting is considered both an unethical and an illegal activity.
An additional impact of naked shorting is that the strategy can have the effect of driving prices on the securities involved downward, sometimes in a manner that is not consistent with the regular pattern of supply and demand for that security. As a result, the instigator of the short sale stands to gain from the ability to purchase shares at those lower rates after the short sale fails, and holding them until their value moves upward once again. At the same time, the investor who purchased the short sale and was anticipating delivery of the purchased securities within the usual three business day period is left with no shares to collect, and no value derived from the transaction. While the buyer is likely to recover the price of the short sale, the time and effort put into the purchase of the short sale is lost.
As online trading has become more common, the incidence of naked shorting has increased. This is because electronic trading systems are sometimes not equipped to cross reference trading activity as efficiently as more traditional methods. While this is changing, the loopholes found in the regulations associated with online trading still make it possible for unscrupulous individuals to create short sales they have no intention of successfully completing. For this reason, investors are often advised to verify the status of the securities associated with the sale, and affirm that the seller does in fact have permission to borrow the stock or that it is at least available for use in the short sale.
While naked shorting has long been considered unethical and has led to banishment from trading on more than one exchange, it is only in recent years that changes in trading regulations on the part of the world’s major investment regulation agencies has aided in curbing the frequency of this type of investment scheme. In the United States, this action took place in 2007 when the Securities and Exchange Commission amended what is known as Regulation SHO to close some of the known loopholes that made the practice possible. This was accomplished by requiring the creation of threshold lists that track stock offerings which appear to have a higher than usual rate of failed deliveries due to short sales.
