Understanding Naked Short Selling: Definition, Risks, and Market Impact

Naked short selling is derived from a practice called short-selling. Short selling is the action of selling assets that have been lent from an investor, with the intent of selling them and then paying back the lender by buying identical assets and returning them. This strategy can only be successful in making money if the stock or property price goes down after receiving money for the lent shares; that way, the short seller can buy the same amount of assets that were lent to him/her for less, which leaves a profit. Example: Dan borrows 100 shares from Tom and gives them to Sam for $1000, then the price of the shares drops by half the next day; Dan then buys 100 shares for $500 and returns them to Tom, keeping the other $500. Basically, short selling is a bet that the company will 'lose' and the share price will drop.

Naked short selling is the same thing without the seller covering their bet. What makes a short sale "naked" is that the party selling the asset never actually borrows or ensures the availability of the asset being sold. This can create a problem for other sellers in the market because it artificially inflates the number of shares... driving the price down. This is the reason the SEC has banned naked short selling. 

If and when the selling party fails to deliver the goods they never secured, it is known as a "failure to deliver." The problem is that although it's illegal not to deliver shares that are fairly bought and sold on the open market, naked short-selling creates the same problem, and is somehow still (technically) legal in the U.S.

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Other Related blog(s): Nouveau Economics, Lyceum Recordz