What is a Naked Shorting?
Naked shorting refers to the practice of shorting units of a given security in advance of ensuring whether or not they can be borrowed.
How Does a Naked Shorting Work?
Traders and investors engage in short selling in order to make a profit by leveraging units of a security borrowed from another investor's portfolio. Short selling is predicated on the investor's belief that a price decline is imminent for some security. By selling the borrowed units prior to this expected decline and then re-purchasing them, the trader makes a profit. The investor who lent the units of stock loses nothing as the price would have declined whether or not the shares had been sold and repurchased.
Naked shorting is the same practice described above, but occurs prior to a trader or investor having secured actual units to sell short. As a result, the trader runs the risk of selling security units which do not exist unless the actual shares can be borrowed before the T+3-day trade settlement period.