The difference between “Short Selling” and “Naked Short Selling”
Many investors use short selling as a way to make money in the stock market, but there are different types of short selling that can have different effects on the market. In this video, we’ll explain the difference between shorting and naked shorting.
Let jump right in.
When an investor shorts a stock, they simply borrow shares of a specific stock from a broker and sell those borrowed shares on the market. The investor hopes that the price of the stock will decrease, so they can buy back the shares at a lower price and return them to the broker, pocketing the difference as profit.
Short selling can be a useful investment strategy for investors who believe that a stock is overvalued and due for a price correction in the short term.
Naked short selling
Naked short selling occurs when an investor sells shares of a stock that they do not actually own or have not borrowed from a broker. This is essentially selling a “phantom” share that does not exist in the market. Naked short selling can artificially drive down the stock price of a stock and can be used as a tool for market manipulation. This is because it allows traders to flood the market with shares of a stock that do not actually exist, potentially leading to distortions in the market.
Naked short selling is illegal in many countries, including the United States. The Securities and Exchange Commission (SEC) has established regulations to prevent the practice of naked short selling. Rule 204 of Regulation SHO requires brokers and dealers to have reasonable grounds to believe that the securities can be borrowed and delivered before executing a short sale order.
Effects on the market
The effects of short selling and naked short selling on the market can be very different. Short selling can contribute to market efficiency by helping to ensure that stock prices reflect all available information. By allowing investors to bet against a stock, short selling can help to correct overvaluation and prevent bubbles from forming. However, “naked short selling” can cause serious harm the market by artificially driving down stock prices and distorting market dynamics, it also has the potential of crashing a stock and/or potentially bankrupting one.
In conclusion, short selling and naked short selling are two different types of investment strategies with different effects on the market. While short selling can be a legitimate investment strategy, naked short selling is illegal and is essentially no different than a dealership selling new cars to customers, collecting funds and completing contracts, all when the dealer never had any cars on the lot!