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Naked short selling is a practice of improperly appropriating a security and arranging an immediate sale of the security. The sale is conducted before the seller has proper ownership or has been authorized to sell the security by the current owner. Naked short selling is conducted with the anticipation of being able to buy back the security at a lower price in short order, thus covering the original sale and managing to make a profit from the venture.
While the strategy of selling a stock short is considered ethical and legal in many parts of the world, naked short selling is considered to be highly unethical in most markets. In many countries, federal laws now prohibit the process of selling stocks short when the seller does not have full and verifiable ownership of the stocks. Even some countries that provide some degree of exemption on the practice of naked short selling will only allow the practice as a strategy to stabilize given market.
The laws governing naked short selling in the United States are fairly representative of the restrictions placed on the practice in many countries around the world. The Securities and Exchange Commission declared general naked shorting illegal in 1934. This effectively abolished the practice in most circumstances. However, the SEC did include a provision allowing market makers to employ the use of naked short selling when the anticipated result was to increase the liquidity of the investment market and help to restore some balance to an unstable situation. Even within the context of this exemption, a 2004 regulation sought to limit the potential for abuse of even this limited utilization of a naked short list.
Legal issues aside, naked short selling carries a relatively high degree of risk. A short sale conducted under these circumstances could easily go sour, leaving the seller in a position of not only failing to realize a profit but to actually incur a substantial loss if the security fails to decrease in value.