What Is Naked Short Selling?

Everyone likes it when markets and stock prices rise, but DIY investors and traders can also make money when prices dip through short selling.

Short selling, or shorting is a trading strategy where investors look to profit from a decline in the price of securities like stocks or currencies.

Short selling explained

Investors can take a short position by borrowing a stock they believe will decrease in value from a broker.

By selling these borrowed shares on the open market at the current market price, the investor aims to later repurchase the same number of shares at a lower price. This is known as covering the short.

The investor will then return the purchased shares to the brokerage firm and pocket the difference between the price at which the shares were sold and the price at which they were repurchased as profit.

How short selling works

For example, if a trader applies some form of market or stock analysis and identifies factors that will likely cause the stock of Company X to fall from its current price of R100, they could:

1. Borrow 100 shares and sell them on the market for R10,000.
2. Wait for the stock price to drop R80.
3. Buy back the 100 shares for R8,000.
4. Return the shares to the broker.
5. Pay the fees and interest from the R2,000 difference and pocket the rest as profit.

Basically, short selling involves rooting against individual companies or the market. While some investors may be opposed to that on principle, others like the potential to earn returns on market or stock movements in either direction.

Using borrowed funds and leverage to trade with margin on a platform like Clarity can also boost potential returns from short selling by offering greater flexibility to generate a profit from downward movements in the prices of stocks or currencies.

However, if the stock price moves higher, the investor could face substantial losses. Known as a short squeeze, short sellers will need to cover the short position or will be forced to do so via margin calls, which lead to major losses. As such, short selling carries more risks than normal stock trading.

Fully exposed with naked short selling

There is another way investors and traders get themselves into trouble with short selling and that’s by doing it naked.

In regular short selling, this process requires the short seller to locate and borrow the shares before the sale. This is a crucial distinction because investors are technically selling something they don’t own.

Naked short selling entails selling stock shares without first borrowing or ensuring that they can be borrowed.

The aim with naked short selling is the same – sell shares and aim to buy them back later at a lower price to make a profit.

If the stock price unexpectedly rises, traders may face unlimited losses since they need to buy the shares to close the position.

This can increase settlement risk because the seller cannot deliver the shares to the buyer within the required timeframe (known as a failure to deliver, or FTD).

This scenario can create a short squeeze, where short sellers rush to buy back shares, pushing prices even higher, which is what happened in the GameStop (GME) short squeeze in 2021.

This can create a liquidity crisis and market panic.

Can short selling cause market manipulation?

Essentially, the seller is creating shares that don’t exist but are still traded, which can create phantom shares in the market.

As such, naked short selling can artificially increase the supply of a stock, potentially driving down its price. If large-scale naked shorting occurs, it can create a false perception of excessive selling pressure.

This can lead to market manipulation and excessive downward pressure on stock prices, which force companies into distress.

For these reasons, naked short selling is generally illegal in most markets, including the US and South Africa, except in specific cases for market-making activities.

Regulators like the Securities and Exchange Commission (SEC) in the US and the Johannesburg Stock Exchange (JSE)’s Market Regulation division monitor and enforce rules against it.

The JSE enforces rules requiring that all short sales be covered, which means traders must borrow the securities before selling them short. This practice ensures that trades align with the actual issued shares, preventing the risks associated with naked short selling.

Retail investors should be aware of how short-selling activities (naked or otherwise) can influence stock prices.

Any suspicious activities picked up by the JSE’s Market Regulation division are referred to the Financial Sector Conduct Authority (FSCA) for further investigation and enforcement actions.