Quick definition A naked short sale is shorting without first locating and borrowing the shares. Naked short selling is illegal under Regulation SHO except in limited circumstances. What it is Normally, before shorting, a broker must locate shares to borrow. If no shares are available, the short cannot execute. In a naked short sale, a seller sells shares they don't own and make no effort to borrow. The trade settles 3 days later (T+3). If the seller has not located shares by settlement, the trade "fails to deliver". Why it matters Naked short selling is prohibited because it could theoretically allow unlimited short sales, which could drive prices to zero through oversupply. Regulation SHO requires brokers to locate shares before executing a short sale. Brokers that execute naked shorts face severe penalties. Technical fails to deliver Settlement timing creates a grey area. A seller can execute a trade without immediately locating shares, relying on finding them before settlement. If they cannot, the trade fails to deliver, which triggers penalties. Fails to deliver are tracked by regulators. High fail rates indicate possible naked short selling. Practical example You short 100,000 shares without locating them. You hope to find them before settlement in 3 days. If you do, the trade settles normally. If you don't, the trade fails to deliver and you face a forced buy-in. Enforcement The SEC and FINRA monitor for naked short selling. Brokers with high fail-to-deliver rates face investigations. Brokers that facilitate naked short selling can be fined or have trading privileges revoked. Controversy Some investors argue that naked short selling enables manipulation and price suppression. Others argue that it is minor and over-regulated. See also - Short Sale - Regulation SHO - Locate Requirement - Settlement
