Naked Short Selling

Naked short selling or naked shorting is the illegal practice of shorting stocks that do not technically exist.

Normally when you short a stock you borrow the stock from your broker and sell it on the open market. This way you are selling shares that actually exist. Eventually you will have to buy that amount to close out the position and return the shares to your broker.

Naked shorting is different. It happens when you short shares on the market without actually borrowing it first. This is widely seen as a bad occurrence because it gives the possibility of shorting an unlimited amount of shares on a stock which could cause a stock to fall faster than normal.

Regulations Against it

In January 2005 the Security and Exchange Commission (SEC) created regulation SHO to limit the possibility of this occurring by requiring a list of stocks with unusually high “fail to deliver” levels to be published.

In 2008 the SEC temporarily banned all short selling on 19 firms deemed systematically important.

How Do You Avoid It?

If you are trading the market and shorting stocks you obviously do not want to do something illegal. So, how can you avoid it? Luckily your broker will keep track of the stocks that they currently own and they will only lend you stocks to short if they have shares of those stocks in supply.

If they do not have shares of that stock in supply you will simply not be allowed to trade it. So, your broker will not fill the order because it is illegal. Most brokers should have a way of letting you know if you can short a stock beforehand so you don’t just make a trade that will not be filled.

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