What is difference between naked short selling and covered short selling?

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justaguide eNotes educator| Certified Educator

Short selling in the context of the equity markets is used with reference to a practice of selling securities which a person does not own when the sale is made. This is done when the price of the security is expected to fall and sellers believe that they could be bought back later at a lower price. As the sale is at a higher price and they are bought at a lower price later, a profit can be made.

Short selling is generally executed by first borrowing securities from someone who has the securities, selling them, later buying them back from the market and returning them to the lender. This is covered short selling.

In naked short selling, traders sell securities without first borrowing them. There is no certainty here that the securities will be later available for the seller to actually deliver to the buyer at the time of delivery. Naked short selling has been considered a way of manipulating the price of securities. As the short sellers can increase supply very fast, there is a rapid drop in the price of the security. Nervous investors then start closing their long positions which continues to increase supply and there is little if any demand. The short sellers are then able to easily buy back what they short sold at a much lower price.

But the chances of default in naked short-selling are also very high as the seller may not be able to buy back the securities from the market later due to a shortage. This is an important reason why naked short-selling is either not allowed in many markets or monitored closely.

pohnpei397 eNotes educator| Certified Educator

When used as a general term, short selling is when an investor "bets" that the price of a stock or bond will fall.  They make a contract in which they promise to sell that asset at a future time for a given price.  The price that they offer is typically lower than the market price at the time the contract is made.  If the price of the stock drops below the price at which they agree to sell, they make money.  If it does not, they lose.

When used referring to a specific transaction, short selling is when the seller has to borrow the stock from a broker, like a mutual fund or pension fund.

In a naked short sale, the investor promises to sell the asset even though they do not currently own it.  This means that they will have to buy the asset before they can sell it.  In a covered short sale, the investor owns the asset already.