What Is a Naked Short in the Stock Market?

A “naked short” refers to a controversial practice where an investor sells shares of a company without first borrowing them or confirming they can be borrowed. This contrasts with traditional short selling, which requires a firm commitment to deliver the shares. The practice has garnered attention for its potential implications on market integrity and fairness. This article explains naked short selling, differentiating it from conventional short sales, detailing its operational aspects, and outlining regulatory measures designed to address it.

Short Selling Fundamentals

Traditional short selling is a strategy for investors who anticipate a stock’s price decline. It involves borrowing shares from a broker and immediately selling them on the open market. The goal is to repurchase the shares later at a lower price, profiting from the difference. For instance, if an investor borrows and sells shares at $50, and the price drops to $40, they can buy them back at $40, return them to the lender, and realize a $10 profit per share, minus any borrowing fees or commissions.

Before a traditional short sale can be executed, a broker must “locate” the shares to be borrowed. This locate requirement ensures shares are available for borrowing and can be delivered to the buyer by the settlement date. The broker typically charges a borrowing fee, which varies based on the stock’s demand and availability. This step ensures transaction integrity and security delivery.

The settlement period for most stock trades in the United States is typically two business days after the trade date, known as T+2. This means the seller must deliver the shares to the buyer within two days. In a traditional short sale, the prior borrowing of shares ensures the seller has the necessary securities to fulfill this delivery obligation. This process helps maintain an orderly and predictable market environment.

The Nature of Naked Short Selling

Naked short selling fundamentally deviates from traditional short selling by bypassing the “locate” requirement. In a naked short sale, an investor sells shares without first borrowing them or verifying their availability. The seller does not possess the shares at the time of sale, nor do they have a definitive plan to acquire them for delivery. The seller assumes they will acquire the shares before settlement.

This practice allows for the theoretical creation of an unlimited supply of shares in the market. Since no shares are actually borrowed, the number of outstanding shares can exceed a company’s legitimate float, potentially diluting the market and influencing stock prices. This introduces a discrepancy where more shares are sold than can actually be delivered, leading to a condition where more shares are sold than physically exist or are available for immediate delivery.

The core distinction between traditional and naked short selling lies in the pre-borrowing or pre-arrangement of shares. Traditional short selling is predicated on the delivery of actual borrowed shares, maintaining a clear chain of custody. Naked short selling operates on the assumption that shares will become available before the settlement deadline, which can be an uncertain proposition.

Operationalizing Naked Shorts and Failures to Deliver

Naked short selling can arise through various operational pathways, sometimes intentionally circumventing rules or due to systemic inefficiencies, errors, or delays in the trade settlement process. One scenario involves market makers, who are permitted to sell shares without a prior locate to facilitate market liquidity. These exemptions are temporary and require the market maker to promptly cover their positions. If these positions are not covered, they can effectively become naked shorts.

A direct consequence of naked short selling is a “failure to deliver” (FTD). An FTD occurs when a seller does not deliver the promised shares to the buyer by the settlement date, which for most equity trades is T+2. In a naked short sale, an FTD is an inherent outcome because the shares were never borrowed or located, making it impossible for the seller to fulfill their delivery obligation. This creates an open obligation where the buyer has paid for shares but has not received them.

FTDs can also result from legitimate operational issues, such as administrative errors, technical glitches, or delays in the transfer of shares. However, when an FTD consistently occurs for a particular security, especially one with high short interest, it often points to unresolved naked short positions. Persistent FTDs can indicate that more shares have been sold than are available for delivery, potentially disrupting the orderly functioning of the market. These failures to deliver introduce uncertainty and can undermine investor confidence.

Regulatory Measures Against Naked Shorting

Regulatory bodies strictly prohibit or heavily restrict naked short selling due to its potential for market manipulation and artificial price suppression. The practice can create an artificial supply of shares, potentially driving down a stock’s price unfairly, which can harm legitimate investors and the issuing company. Regulators also aim to prevent naked shorting from undermining the integrity and efficiency of securities markets. Unfulfilled delivery obligations can disrupt the settlement process and increase systemic risk.

In the United States, the primary regulation addressing naked short selling is Regulation SHO, implemented by the Securities and Exchange Commission (SEC). A central component of Regulation SHO is the “locate” requirement, which mandates that participants must have a reasonable belief that shares can be borrowed and delivered before executing a short sale. This rule aims to prevent the sale of shares that do not exist or cannot be obtained. The locate requirement applies to all short sales, with limited exceptions for bona fide market making activities designed to maintain market liquidity.

Regulation SHO also includes provisions to address persistent failures to deliver. These provisions include “close-out” requirements, which mandate that participants who fail to deliver shares must buy them in the open market within a specified timeframe. This mandatory buy-in mechanism is designed to prevent FTDs from accumulating indefinitely and to force the delivery of shares, thereby mitigating the negative effects of naked short selling on market stability and price discovery.