Naked Shorting

Definition

Naked shorting refers to the illegal practice of selling short a financial security without actually borrowing or owning the shares. Traders engage in naked shorting to profit from anticipated price declines without having to deliver the shares to buyers. This practice can lead to market manipulation, as it allows traders to artificially increase the supply of shares, putting downward pressure on the security’s price.

Phonetic

The phonetic spelling of “Naked Shorting” using the International Phonetic Alphabet (IPA) is:ˈneɪkɪd ˈʃɔrtɪŋ

Key Takeaways

1. Naked shorting is an illegal practice where a person or company sells shares of a stock that they do not actually own, with the intention of buying them back at a lower price to make a profit.
2. It can have negative consequences for the targeted stock, as it artificially increases selling pressure and lowers the stock’s value, potentially leading to financial harm for legitimate investors.
3. Regulatory authorities, such as the Securities and Exchange Commission, have implemented regulations to prevent naked shorting and work to enforce these rules to protect investors and maintain the integrity of financial markets.

Importance

Naked shorting is an important business/finance term because it refers to an illegal practice where short sellers sell shares they haven’t borrowed, with no intention of delivering those shares to the buyer, which often leads to potential market manipulation. This controversial strategy often exacerbates price declines in targeted stocks, causing artificial volatility, and harms the businesses’ value and investor confidence. As a result, regulatory actions have been taken by authorities such as the Securities and Exchange Commission (SEC) to curb this malicious activity, ensuring fair market practices and protecting the integrity of financial markets.

Explanation

Naked shorting, an advanced trading strategy, is employed by investors who speculate that a stock’s price will decline in the future. Typically, a trader might borrow shares in a stock and sell them short, betting that the price will fall and they can subsequently buy the shares back at a lower cost to return to the lender, thus making a profit from the price difference. However, naked shorting circumvents the traditional short-selling process by not actually borrowing the shares or even ensuring their availability. This means the trader sells shares they neither own nor have arranged to borrow. Naked shorting can be utilized for various reasons, but primarily serves as a method of exerting downward pressure on a stock’s price or creating the appearance of increased trading activity to influence market sentiment. While naked shorting has the potential to generate substantial profits for investors, it is important to recognize that this practice comes with a fair share of risks and ethical concerns. The primary risk lies in its potential to cause artificial price manipulation, with traders selling large volumes of non-existent shares, which can lead to panic selling and unwarranted price drops. As a result, many financial regulators, including those in the United States, have taken measures to curb naked shorting by enacting stricter rules surrounding the borrowing and lending of securities. Despite its limited use and legal restrictions, naked shorting remains a contentious issue within the financial world, and understanding its purpose and applications can help provide insight into broader market forces and trends.

Examples

Naked shorting, also known as naked short selling, is an illegal practice in which investors sell shares of stock they do not own, have not borrowed, and have not ensured they can borrow. Here are three real-world examples of naked shorting: 1. Overstock.com case (2007)In 2007, Overstock.com filed a lawsuit against several hedge funds and brokerage firms, accusing them of naked short selling. The company claimed that the defendants were conspiring to manipulate the market by engaging in naked shorting. They alleged that this manipulation depressed the company’s stock price, causing harm to their business. In 2010, Overstock.com reached a settlement with the brokerage firm Goldman Sachs, though specific details of the settlement remain undisclosed. 2. Porsche and Volkswagen case (2008)During the 2008 financial crisis, German automaker Porsche was in the process of acquiring a majority stake in Volkswagen. Hedge funds and other investors who were short-selling Volkswagen shares ended up in a short squeeze when Porsche revealed that it held a much larger stake in Volkswagen than was previously disclosed. Many short sellers were assumed to have engaged in naked shorting, leading to a sharp rise in Volkswagen’s share price. At one point, Volkswagen briefly became the most valuable company in the world due to this short squeeze. Eventually, market regulators tightened the regulation on short selling to curb such behavior. 3. Lehman Brothers case (2008)Lehman Brothers, a global financial services firm, filed for bankruptcy in September 2008, contributing to the global financial crisis. Prior to their collapse, there were numerous instances of suspicious trading activity involving Lehman Brothers’ stock. This activity included significant volumes of failed trades, suggesting that naked short selling may have played a role in driving down the company’s share price. Although naked shorting has not been proven conclusively in this case, the Securities and Exchange Commission (SEC) adopted new rules in the aftermath to curb naked short selling and improve transparency in the markets.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Fail to Deliver (FTD)
• Short Interest
• Locus Sale
• Regulation SHO
• Securities Lending

Sources for More Information

• Investopedia
• Wikipedia
• Corporate Finance Institute
• WallStreetMojo