What is Naked Short Selling?

Naked short selling is a practice that involves short selling a security without having the ability to cover the transaction. This practice has been done in many financial markets over the years and is a strategy that should be considered high risk/high reward. Here are a few things to consider about naked short selling and how it works.

Short Selling

In order to understand naked short selling, you first have to understand what short selling is and how it works. In the financial markets, if you want to bet on a particular security going down in value, you can utilize what is referred to as a "short sale". With this transaction, you are selling a security because you believe that the price will go down significantly. With this transaction, you are essentially selling the security at a higher price and then buying it at a lower price. With traditional short selling, you have to be able to borrow the security from someone else before you can complete the trade. Many times, this requires a margin account with your broker. You will be borrowing the securities from your broker who might actually borrow them from another broker. 

Naked Short Selling

Even though the process of naked short selling is similar, there is one key difference between it and traditional short selling. With naked short selling, you sell the security even though you do not actually have access to it. You might engage in the transaction without checking with your broker to see if they can get the shares first.

High Risk

This strategy carries with it even more risk than traditional short selling. With a naked short sale, you are taking a big risk because you do not know if the securities will be available for you to borrow or purchase. In some cases, you may not be able to find the securities after you enter into a trade. At that point, you would not be able to deliver the securities to the other individual. If the trade goes against you, it could end up costing you substantially. 

Outlawed

In the United States, the practice of naked short selling has been banned. During the 2008 financial crisis in the United States, they banned this practice because of the irresponsible nature of it. Traders have to have access to the securities that they want to short sell before the transaction takes place.

Liquidity

Naked short selling is a procedure that is generally related to the level of liquidity of a particular security. Many times, when a security is not readily available in the market, individuals will engage in naked short selling. By doing this, they can still get involved in the market even though they're are not an abundance of sellers that are willing to part with the security. In some cases, this can actually improve the level of liquidity in the market as it attracts more investors to the security. 

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