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.
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