What is Naked Short Selling? Is it Banned? Explained

Have you ever heard traders talk about short selling and wondered how one can profit when stock prices fall? Now, imagine someone selling shares they don’t even own – sounds risky, right? That’s exactly what is naked short selling.

It is one of those trading practices that are controversial and may cause a commotion in the markets and capture the eyes of the regulatory bodies such as the SEBI (Securities and Exchange Board of India).

We are going to dissect in this blog what is naked short selling, how it is done, what SEBI has to say on it and is short selling in india permissible. We should get into the water and see the sense of this multifaceted but intriguing subject.

What is Short Selling?

Short selling is a trading technique where traders sell a stock they do not own in the hope they can re-buy it at a later time at a lower price. The goal? Gain when stocks are at a lower price.

You can borrow stocks through a broker, sell in the market and repurchase them later when the stock falls and give the stock back to the person who lent you the stock and get the difference.

Take the example of borrowing the cricket bat of your friend and selling the bat at a high price and then later getting it back when the price is low and retaining the profit!

How Does Short Selling Work?

Here’s a step-by-step breakdown of What is Short Selling? And how short selling works:

Borrow Shares: The trader borrows shares from a broker.
Sell in the Market: Selling of shares at the current market price.
Wait for Price Drop: The trader waits for the stock price to fall.
Buy Back: Shares are bought back at the lower price.
Return Shares: The borrowed shares are returned to the broker.
Profit: The trader earns the price difference (minus brokerage and interest).

Example: A trader borrows 100 shares of Company X at ₹200 each and sells them. When the price drops to ₹150, they buy back the shares and return them – making a ₹5,000 profit (₹50 × 100).

What is Naked Short Selling?

Naked short selling takes the short-selling concept one risky step further. Here, traders sell shares without borrowing them first or even ensuring they can borrow them later.

That means – they promise to deliver shares they don’t actually have!

This can lead to market instability because it creates selling pressure without the actual delivery of shares, often resulting in artificial price declines.

How Naked Short Selling SEBI Works

Here’s how it usually happens:

A trader decides to sell shares they don’t own.
They execute the trade without borrowing shares.
When the buyer requests delivery, the seller fails to deliver.
This creates a “fail-to-deliver” situation in the clearing system.

Such trades distort demand-supply balance and can manipulate stock prices, which is why SEBI has banned it.

Why Traders Engage in Naked Short Selling

Even though it’s banned, some traders still attempt it for speculative or manipulative reasons:

To profit from rapid price falls.
To create panic selling among investors.
To influence stock prices for arbitrage or insider advantage.
To exploit settlement loopholes temporarily.

These activities may lead to severe fines and penalties on trading.

Risks and Market Impact

Naked short selling is often linked with market manipulation. Here are the major risks:

Artificial Price Declines – It can push prices down unfairly.
Settlement Failures – Buyers may not get shares on time.
Loss of Investor Confidence – Targeted Investment Loss Loss of Investor Confidence Market integrity is harmed.
Regulatory Action- Traders will face punishment and suspension.

Briefly, short selling is beneficial in ensuring liquidity in the market whereas naked shorting is detrimental to stability.

Difference Between Covered and Naked Short Selling

Basis	Covered Short Selling	Naked Short Selling
Ownership of Shares	Shares are borrowed before selling.	Shares are not borrowed or confirmed.
Legality in India	Allowed under SEBI guidelines.	Prohibited by SEBI.
Market Impact	Limited and controlled.	Can cause artificial price drops.
Settlement Risk	Minimal.	High risk of settlement failure.

In short – covered short selling = legal, naked short selling = illegal in India.

Naked Short Selling SEBI Guidelines

The SEBI guidelines are very clear – naked short selling is prohibited in India.

Only covered short selling is allowed.
Institutional investors must disclose short positions.
Retail investors can short sell in intra-day trading only.
All trades must be settled through delivery obligations.
Brokers should make sure the client does not sell the shares that he does not own or borrow.

These norms were incorporated by SEBI to make the Indian stock market transpire, fair and stable.

Is Short Selling allowed in India?

Yes – in India it is also permissible to short-sell though within the strict guidelines of SEBI.

Retail traders can short sell intra-day – meaning they must square off the position before the market closes.
Institutional investors can short sell, but they must borrow shares first through approved mechanisms.

Any trade beyond these limits may be considered naked short selling and lead to penalties.

Global Perspective: How Other Markets Regulate It

Different countries treat naked short selling differently:

Country	Regulation Status
USA (SEC)	Banned under Regulation SHO.
UK (FCA)	Prohibited after the 2008 financial crisis.
Australia (ASIC)	Allowed only under strict conditions.
India (SEBI)	Completely banned.

Globally, regulators agree that naked short selling undermines market integrity and must be restricted.

SEBI’s Measures to Prevent Market Manipulation

To prevent illegal short selling, SEBI has implemented:

Automated settlement systems to detect delivery failures.
Penalty frameworks for “fail-to-deliver” positions.
Surveillance mechanisms to track unusual trading patterns.
Reporting norms for large short positions.

These measures ensure India’s stock market remains transparent and fair.

Pros and Cons of Short Selling

Advantages	Disadvantages
Provides liquidity	Can destabilize prices
Enables hedging	Risk of unlimited losses
Helps price discovery	Regulatory scrutiny
Profit from falling prices	Not suitable for beginners

How Retail Investors Can Legally Short Sell

Retail investors in India can short sell only during the same trading session.

Here’s how you can do it safely:

Choose a liquid stock with high trading volume.
Place a short sell order during the market session.
Monitor the price – aim to buy back before the market closes.
Square off the position before 3:30 PM.

If you don’t square off, your broker may automatically close your trade – and losses can occur.

Example of Short Selling in the Indian Market

Let’s say a person expects XYZ Ltd. to fall from ₹500 to ₹450.

She sells 100 shares of XYZ at ₹500 each.
By 2 PM, the stock drops to ₹450.
She buys back all 100 shares at ₹450.
Her profit = ₹5,000 (₹50 × 100 shares).

This is a legal covered short sale since she completed the trade within the day.

Conclusion

To sum up, naked short selling is like trying to sell an empty box – you promise to deliver something you don’t have. Such practices do not damage fairness and trust among investors as SEBI is strict in enforcing these practices.

Whereas short selling may be an effective instrument to the intelligent trader, naked short selling is prohibited since it may generate artificial panic and manipulation. I advise you to always stick on to the rules of SEBI, remain updated and trade responsibly.

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