Naked short selling takes the whole process of selling a stock short one step further, but before you can understand naked short selling, you must understand the basic process of short selling stocks.
What is short selling?
The traditional process of short selling stocks involves selling borrowed stocks. In traditional short selling, the seller borrows stocks from a shareholder for sale, but must buy stocks to fulfill the sale. Selling a stock short is a practice investors use when they expect the price of a security to fall; they sell the stock at a high price, but when the stock price falls, they then buy at a low price to complete the transaction. In traditional short selling, the stock must be borrowed, or an attempt to borrow the stock must be made.
Naked short selling differs from traditional short selling in that there is no attempt to borrow the stock from a shareholder. In naked short selling, the seller simply doesn't have a stock to sell; the trade is then written off due to a failure to deliver, or the order is held indefinitely until the seller obtains the stock to sell.
The dangers of naked short selling.
The practice of short selling stocks can be controversial, but many investors don't blink at the thought of traditional short selling. Naked short selling, however, is a far more serious matter; selling something that the seller doesn't possess has serious economic and ethical implications. Naked short selling in large quantities drives the price of a stock down, resulting in huge losses for the company and shareholders, but potential profits for the investor. When the price drops as a result of naked short selling, investors snap up the stocks and make a tidy profit, selling high and buying low.
Because naked short selling is such a potentially dangerous practice for the stock market, the U.S. Securities and Exchange Commission, or SEC, has implemented various regulations against naked short selling in the recent past. After various temporary bans, the SEC has now enacted a permanent ban that effectively prohibits naked short selling.
Current short-selling rules.
In light of volatility in the stock market and reports of short selling fraud in 2007-2008, the SEC has implemented a new set of rules surrounding short sales. Sellers are required to deliver stocks or other securities within three days of the sale, or face fines and penalties. If the seller is unable to deliver the securities, then no other short sales in that security may occur until the security is delivered. Further, any case where a seller intentionally misleads buyers about the ability to deliver a security is considered a violation of the law, effectively banning naked short selling.
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