What it means
Short selling is a bet that a share price will fall. The trader borrows shares from a lender, sells them in the market, and later buys them back to return to the lender, ideally at a lower price.
The difference is the profit, less borrowing costs. In naked shorting, the trader skips the borrowing step.
The shares are sold, but the seller does not have them and may not be able to deliver them on the settlement date. This is called a failure to deliver, and it can leave the buyer with a claim on shares that do not exist yet.
Regulators worry that large-scale naked shorting can push prices down artificially, because it adds selling pressure without the usual limit that shares must exist to be borrowed. In the United States, rules generally require a seller to locate shares that can be borrowed before shorting, and many other markets have similar restrictions or bans.
Market makers, who provide liquidity, have sometimes been given limited exemptions for genuine market-making activity. Even so, persistent delivery failures can trigger penalties and forced buy-ins, where the missing shares are purchased on the seller's behalf.
The profit and loss mechanics are the same as for ordinary short selling, and the losses can be unlimited because a share price can keep rising. For a non-finance reader, the key point is that the practice is controversial, heavily regulated, and generally not something a company treasury would ever do.
Supporters of short selling in general argue that it helps markets find fair prices and exposes overvalued firms. Critics of naked shorting argue that it goes beyond that useful role, because selling shares that do not exist can create more sell orders than there are real shares.
In practice
Real-world examples.
Example
A hedge fund sells shares of a small mining company short without locating any to borrow. The sale does not settle on time, and the broker is fined for failing to enforce locate rules. The fund must also buy the shares back quickly to close the gap.
Example
A listed biotechnology company notices persistent failures to deliver in its shares and suspects naked shorting. Its general counsel writes to the regulator and the exchange asking for an investigation. The letter includes a month of settlement data showing repeated delivery failures.
Example
A market maker sells shares to meet customer demand in a thinly traded stock, and has a short exemption for doing so. It buys the shares back within a day, so the delivery gap is brief and permitted.
Formula
Calculation
Profit or loss on a short sale = (Sale price - Buyback price) x Number of shares
A trader sells 1,000 shares at $50, receiving $50,000. If the price falls and she buys the shares back at $42, the cost is $42,000, and the profit is ($50 - $42) x 1,000 = $8,000.
If instead the price rises to $65, buying back costs $65,000 and the loss is ($50 - $65) x 1,000 = -$15,000. If the price rose to $100, the loss would be $50,000, equal to the original proceeds, and it would keep growing without any ceiling.Case study
Seen in the real world.
Greenfield Biologics is an illustrative, fictional listed company. After a disappointing trial update, its share price fell 40% in three weeks, and the investor relations team noticed unusually large trading volumes with little real change in shareholder registers.
The company's lawyers asked its broker for data on settlement failures and found that delivery failures in the stock were running far above the market norm. They filed a formal complaint with the exchange and regulator.
In this illustrative story the regulator found that two trading firms had sold shares without locating them, and fined both. The case shows why locate rules exist and why delivery failures are a red flag. Greenfield also began checking settlement data monthly.
Watch out
Common mistakes.
- Confusing naked shorting with ordinary short selling, which is legal and relies on borrowed shares.
- Blaming every share price fall on naked shorting, when most declines reflect real news or investor sentiment.
- Believing losses on short positions are limited to the amount invested, when they can be unlimited.
Questions
People also ask.
Is naked shorting illegal?
In many markets it is restricted or banned, and in the United States rules generally require shares to be located before a short sale.
What is a failure to deliver?
It happens when a seller does not deliver the shares to the buyer by the settlement date. Small numbers of failures happen for innocent reasons, so persistent or large ones are what attract scrutiny.
Why do companies complain about it?
They fear that selling without borrowed shares can depress their share price and weaken confidence among investors. They also worry about the cost of defending the stock and reassuring shareholders.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related