Why Investing in Canadian Small Caps Can Be Brutal: Naked Short Selling Explained

I’ve heard a ton about naked short selling over the years, and I kind of understood what it was, but I never really got why it’s such a big issue in Canada. After looking into it more, it’s clear this is something anyone investing in Canadian small caps should at least be aware of.

Short selling itself isn’t the problem. That’s just when someone borrows shares, sells them, and buys them back cheaper to return to the lender. If they guess right and the stock drops, they make money. It’s a normal market function.

Naked short selling is a whole different story. Instead of borrowing shares before selling, traders just sell them without actually owning or locating them. These shares don’t exist, but the sale still goes through, creating artificial selling pressure.

The issue is that when too many of these phantom shares hit the market, it makes it look like there’s way more selling than there actually is. The price drops, not because investors are dumping shares, but because the market is reacting to fake supply.

This is brutal for small caps, especially junior miners in Canada. Big stocks have enough liquidity to absorb short selling, but small stocks don’t. If there’s even a little naked shorting, it can completely crush a stock that should be moving up on good news. And that’s not even getting into predatory short selling. The goal there isn’t just to make money on a trade, it’s to actively beat a stock down. You see it in juniors all the time. Trades that aren’t about finding the best price, they’re about creating the worst price. It’s another layer of risk for small-cap investors.

That’s why Save Canadian Mining, an advocacy group led by Terry Lynch and backed by investors like Eric Sprott and Rob McEwen, has been pushing for the return of the uptick rule. For decades, short sellers in Canada could only short on an uptick or a flat trade, meaning they couldn’t just hammer a stock lower at will. That changed in 2012 when the rule was scrapped, and since then it’s been open season on small caps. Bringing it back would make it harder for predatory shorts to pile on and create artificial chaos in thinly traded names.

Some companies are also fighting back directly. Power Nickel filed complaints with regulators in late 2023, showing data that millions of their shares had been sold but never delivered. You’d think regulators would be all over that, but apparently not. They barely responded, and nothing really came of it.

Meanwhile, the U.S. has actually started cracking down. In 2023, a legal change made brokers responsible for their clients’ illegal naked shorting. If a trader sells shares they don’t own and it causes damage to a company, the broker can now be held legally accountable. That forces brokers to actually pay attention instead of just looking the other way.

Canada has at least tried to start tightening things up. In late 2024 regulators approved a rule that forces dealers to have a reasonable expectation they can settle before shorting. It’s basically a formal “locate” requirement, and it officially kicked in this April. It’s not a full fix. Complaints about failed trades are still around, but it does bring Canada a bit closer to the U.S. system. And even there, with stricter rules on paper, investors still argue naked shorting slips through. At the end of the day, enforcement matters more than the rulebook.

So where does this go from here? In the U.S., lawsuits against brokers are picking up, and firms are being forced to take this issue more seriously. In Canada, it’s still business as usual.