What Is Naked Short Selling, How Does It Work, and Is It Legal?

Naked Shorting

Investopedia / Laura Porter

Naked short selling is a notorious trading practice that has been largely banned in the U.S. and EU since the period around the 2007-2008 crisis. But that doesn't mean the practice still doesn't occur. Naked shorting is when a trader sells shares in some asset without first borrowing them or ensuring they could be borrowed. The aim is to profit from a decline in the asset's price by later buying the shares at a lower cost to cover the short position. This is different from traditional short selling, when you borrow the shares before selling them.

Key Takeaways

  • Naked shorting is the illegal practice of selling short shares that have not yet been determined to exist or that the trader hasn't secured in some way.
  • Ordinarily, traders must first borrow a stock or determine that it can be borrowed before selling it short.
  • Because of loopholes in the rules and discrepancies between paper and electronic trading systems, naked shorting continues to happen, a process the Securities and Exchange Commission (SEC) has been working to clamp down on through newer transparency rules.

The legality of naked short selling varies by jurisdiction and is subject to complex regulations. In the U.S., the Securities Exchange Commission (SEC) implemented its Regulation SHO in 2005 to curtail the practice, requiring broker-dealers to have reasonable grounds for believing that shares could be borrowed before the short sale. Despite these and other regulations, naked short selling still can occur, which the SEC says leads to market manipulation.

Understanding Naked Shorting

You're engaged in naked short selling when you sell shares in an asset without owning, borrowing, or securing the right to borrow them. Unlike traditional short selling, when you borrow the shares before selling them, in naked short selling, you haven't taken on the greater risk of borrowing the asset first.

The practice is highly risky and could lead to unlimited losses. The SEC and other regulatory bodies, such as the European Securities and Markets Authority (ESMA), say it contributes to market volatility and is highly unethical. You're distorting the regular supply and demand of a security and taking on risk that you might try to flee from—all by selling a right to something you don't have. While naked short selling could offer lucrative profits, the risks and ethical considerations make it highly scrutinized and illegal.

The naked short-selling process

The method of naked short selling involves two main steps. First, you sell shares without owning, borrowing, or securing the right to borrow them. Later, you purchase and deliver the shares at the market price, hoping for a profit. If you can't afford the shares or if they aren't available, the result is a failure to deliver (FTD).

Let's use a simplified example: suppose you sell short 1000 shares in Company A. You haven't borrowed the shares. Still, you're betting on a rapid downturn in the stock price for Company A, which makes this not a problem—the price going down should mean there are many sellers looking to get out of their positions. Just before the deadline to deliver the shares, the price moves downward, and you close out the short sale for 1000 shares at the lower price. You've essentially bet you could square up for the shares you sold that you didn't possess. However, if the market moved the other way, you'd be in a big hole trying to purchase 1000 shares of a stock at a great loss, and the shares might not even be available if there are problems in liquidity.

The market impact of naked short selling

Short selling in general can create declines in a company's stock price, affecting its ability to raise capital. It can also affect the liquidity of the security. When a share isn't readily available, naked short selling gives you a shortcut; you can participate in the market even though you didn't borrow the share. This could create false liquidity readings, which could distort the share price.

Naked shorting was precluded in regulatory changes in 2005, but further regulatory scrutiny jumped after the 2007-2008 financial crisis in reaction to the piling on of shorts for failing financial giants Lehman Brothers and Bear Stearns.


Is Naked Short Selling Legal?

Naked short selling is illegal in the U.S. and many other jurisdictions. The SEC banned naked short selling totally following the 2007-2008 financial crisis. Before this, the SEC had implemented and amended its Regulation SHO to close loopholes that allowed some brokers and dealers to engage in naked short selling. Regulation SHO now requires the publication of lists that track stocks with unusually high trends in FTD shares.

Why Is Naked Short Selling Illegal?

The practice of naked short selling is illegal for several reasons:

  • Market manipulation: Naked short selling could artificially depress stock prices, a form of market manipulation.
  • Transparency and the potential for fraud: The practice can throw off supply and demand in the market as high quantities of shorts are on shares that aren't secured. This could make trading in certain securities unfair and untrustworthy.
  • Financial risk: Naked shorting creates a dangerous environment for retail investors, as it allows the sale of nonexistent shares, giving the seller the power to depress particular share prices.

The History of Naked Short Selling

Short selling is a practice that members of the public often find outrageous; someone is profiting when a company is facing a downturn. Yet, modern hedge funds, which started after World War II, and many portfolios rely on shorting practices to balance out risks in the market.

Short selling dates back at least to 1609 when Dutch trader Isaac Le Maire targeted the shares of the Dutch East India Company. Short selling was later blamed for economic downturns, such as the speculative peak in the trading of tulips in the early 1630s in the Netherlands. In 1773, Britain was the first country to ban naked short selling.

Several centuries later, after the Wall Street crash of 1929, short sellers were among those blamed, leading to the institution of the Uptick Rule, which banned short selling when securities were not trending upward in price. From 2005 to 2010, the SEC ratcheted up regulations meant to ban naked short selling altogether.

Notorious Examples of Naked Short Selling

The best-known modern example of naked short selling is from the collapse of Lehman Brothers in 2008. SEC data indicated a more than 57-fold increase in FTD in Lehman Brothers’ shares that year, compared to 2007. This could indicate naked short selling. Lehman’s CEO Dick Fuld testified before Congress that naked short selling essentially precipitated the company’s downfall, though later analyses claimed otherwise.

More recently, naked shorting was partially blamed for the GameStop “meme stock” phenomenon of 2021. During the two previous years, GameStop had posted big losses, leading to a large drop in its share prices. This problem was noticed by hedge funds, which took out major short positions in the stock. In 2020, at least half of GameStop’s stock was borrowed for short positions. By 2021, 140% of GameStop shares were shorted, meaning 40% of the shares shorted weren’t really out there to trade on; that is, they were likely involved in naked short sales. Online investors soon noticed this giant hedge, setting up the Reddit forum “r/WallStreetBets” to implement a short squeeze and bid up the stock to counter the shorting of the hedge funds. As the share price increased, it wasn’t just the hedge funds that lost; short sellers who hadn’t borrowed the shares couldn’t deliver.

A scheme close to the idea of naked shorting is featured in Mel Brooks’ The Producers. The setup for the movie and subsequent Broadway hit is that a shady theater producer, Max Bialystock, has sold 100% of the shares in a new Broadway play several times over. The problem is that if the play makes money, the investors will come for it—too many investors. But if it’s a flop, no one will expect a return. Hence, the scheme that sparks the machinations of The Producers: a venture so implausible, so offensive, that no self-respecting theatergoer would show up, it would flop, and the producers could escape.

Rules on Short Selling

Short selling rules have evolved to prevent market manipulation and abusive practices. The SEC's Regulation SHO provides the framework for short selling and a ban on naked short selling. In 2010, the U.S. SEC adopted its alternative uptick rule, designed to restrict short selling from further driving down the price of a stock. Essentially, it's meant to prevent sales of shorts on stocks that have dropped more than 10% in one day.

Additions to Regulation SHO from the SEC in late 2021 and early 2022 require firms lending out shares for shorts to report that activity to the Financial Industry Regulatory Authority. This data is reported in aggregate for given securities on a delayed basis.

The new rules implementing greater transparency could have a significant impact on naked short selling. By requiring investors and companies to report their short positions and lending activities, the SEC is essentially trying to close loopholes that make naked short selling possible.

Rules on short selling outside the US

Regulations concerning short selling vary significantly outside the U.S. In the EU, ESMA oversees short selling. ESMA requires disclosure of net short positions when they reach 0.2% of the issued share capital of a company and at each 0.1% increment above that.

Post-Brexit, the United Kingdom has had regulations similar to the EU under the Financial Conduct Authority (FCA). The FCA also has the power to ban short selling of specific stocks in extreme cases. In Japan, the Financial Services Agency has its own version of the uptick rule, which requires short selling only at a price higher than the latest market price.

The Securities and Futures Commission in Hong Kong allows only “covered” short selling, meaning that the investor must have shares available to borrow before initiating a short sale. The Australian Securities and Investments Commission requires disclosing short positions, and it has the power to ban short sales during turbulent market conditions.

What Does Short Covering Mean?

Short covering is buying back a security that has been short-sold to close out an open-short position. This is done either to lock in a profit or limit a loss.

What Is a Short Squeeze?

A short squeeze occurs when the price of an asset, typically a stock, rises a lot, forcing traders who had bet against it to buy to forestall even greater losses. These purchases could drive the asset's price up further, creating a feedback loop that could result in dramatic price increases. This is believed to have occurred during the GameStop phenomenon of 2021.

What Is Securities Lending?

Securities lending is when an owner of securities loans them to a borrower, typically in exchange for collateral and a fee. The borrower is then obligated to return the securities on demand or at the end of a specific lending period. The collateral could be in the form of cash or other securities. During the lending period, the lender retains the economic benefits of the securities, such as dividends or interest payments, but temporarily transfers the voting rights to the borrower.


The practice is commonly used by institutional investors and brokerage firms to enable short selling or to earn more income on idle assets.

What Is Covered Call Writing?

Covered call writing is an options trading strategy when an investor holding a long position in an asset writes or sells call options on it. The aim is to generate additional income from the asset, usually from the premium received from selling the call option.

What Is a Synthetic Short Forward?

A synthetic short forward is a financial derivative strategy replicating a short forward contract using other financial instruments, typically options. The aim is to benefit from the expected decline in the price of an underlying asset without actually shorting the asset itself.

The Bottom Line

Naked short selling is a high-risk and ethically dubious financial practice where an investor sells a security, often shares of stock, without first borrowing the asset or ensuring its availability for borrowing. The process involves selling shares one does not own and later buying them back to cover the position. This exposes the seller to significant financial risks, including “failure to deliver” if the shares cannot be procured.

In terms of legality, naked short selling is generally banned. In the U.S., SEC rules, including “Regulation SHO,” mandate that broker-dealers have reasonable grounds to say that shares will be available for delivery before facilitating short positions. Additional restrictions put in place in the early 2020s call for greater transparency in short sales and should make it more difficult for naked short selling to occur. Further, every country sets its own rules for short selling.

Article Sources
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