# Naked Short Selling Explained: Process, Impacts, and Legalities

![Naked Shorting](https://www.investopedia.com/thmb/459-CMpj3638UXzjPs-t9YoCt5c=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/nakedshorting-final-edit-352e2d142f2d43288a25cf9e5a926471.jpg)

*— Investopedia / Laura Porter*

## What Is Naked Short Selling?

Naked short selling is a controversial practice where traders sell assets without first borrowing them. This can cause a supply shortage of shorted securities, potentially impacting market prices. Despite being largely banned in the U.S. and the EU following the 2008 financial crisis, the practice persists due to regulatory loopholes, which affect market stability and transparency.

### Key Takeaways

*   Naked short selling involves selling shares that haven't been borrowed, making it a risky and illegal practice in many jurisdictions.
*   It can lead to market volatility and is considered unethical due to its potential to manipulate stock prices.
*   Regulatory bodies, like the SEC, have set rules to curb naked short selling through measures like Regulation SHO.
*   Despite being banned, naked short selling can still occur due to loopholes and oversight challenges in trading systems.
*   Recent examples, such as the 2021 GameStop incident, highlight the impact of naked short selling on market dynamics.

## Exploring the Mechanics of Naked Short Selling

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 the European Securities and Markets Authority (ESMA) consider it highly unethical and believe it contributes to [market volatility](https://www.investopedia.com/terms/v/volatility.asp).

Selling what you don't have distorts security supply and demand and increases risks you may want to avoid. Naked short selling might be profitable, but high risks and ethical concerns make it illegal and heavily scrutinized.

## How the Naked Short Selling Process Unfolds

The method of naked short selling involves three steps:

1.  **Initiate the Sale**: Sell shares without owning, borrowing, or securing the right to borrow them.
2.  **Hope for Market Decline**: Bet on a price drop to buy shares at a lower cost to cover the short position.
3.  **Potential Failure**: If shares can't be purchased affordably or aren't available, a failure to deliver occurs.

### The Market Implications 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](https://www.investopedia.com/articles/basics/07/liquidity.asp) 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.

> **Important**
>
> Naked shorting was barred in 2005, with increased scrutiny after the 2007-2008 crisis when shorts piled onto Lehman Brothers and Bear Stearns.

## The Legality of Naked Short Selling

The legality of naked short selling varies by jurisdiction and is subject to complex regulations. The SEC introduced [Regulation SHO](https://www.investopedia.com/terms/r/regsho.asp) in 2005, requiring broker-dealers to ensure shares can be borrowed before short selling.

The SEC completely banned naked short selling following the [2007-2008 financial crisis](https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp). 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. Despite these and other regulations, naked short selling can still occur, which the SEC says leads to market manipulation.

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.

## A Historical Perspective on 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](https://www.investopedia.com/terms/u/uptickrule.asp), 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.

## Real-World Examples of Naked Short Selling

The best-known modern example of naked short selling is from the collapse of [Lehman Brothers](https://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp) in 2008. SEC data indicated a more than 57-fold increase in FTD in Lehman Brothers' shares that year, compared to 2007. This suggests the presence of 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](https://www.investopedia.com/meme-stock-5206762)" 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](https://www.investopedia.com/articles/personal-finance/081616/benefits-and-rewards-gamestop-credit-card-gme-bby.asp) 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's "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.

## Essential Rules Governing 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 transparency rules could significantly impact 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.

### Global Short Selling Regulations and Practices

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](https://www.investopedia.com/terms/b/brexit.asp), 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 an illegal and high-risk financial practice that involves selling securities without borrowing them first, leading to significant financial risks, such as "failure to deliver" if the shares can't be secured. While tempting for its potential profits, it is widely banned due to its potential for market manipulation and the distortion of supply and demand dynamics. In the U.S., the SEC's Regulation SHO underscores the importance of ensuring that shares are available before short selling, and additional measures introduced in the early 2020s aim to enhance transparency in the market.

Globally, regulatory responses vary, but the consensus leans toward stringent rules to prevent such unethical trading activities. Investors should be aware of the legal and financial repercussions of engaging in naked short selling.

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