Ask TheStreet: Naked Shorts

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What is "naked" shorting? And why is it so difficult to prove? Thanks, D.M.

The Securities and Exchange Commission Chairman Christopher Cox on Tuesday said the regulator planned to crack down on naked short-selling of Fannie Mae (FNM - Cramer's Take - Stockpickr) and Freddie Mac. Cox said in a testimony to the Senate Banking Committee on Tuesday that the agency will require short-sellers to borrow shares of the two government-sponsored mortgage giants and broker dealers including Lehman Brothers (LEH - Cramer's Take - Stockpickr), Goldman Sachs (GS - Cramer's Take - Stockpickr), Merrill Lynch (MER - Cramer's Take - Stockpickr) and Morgan Stanley (MS - Cramer's Take - Stockpickr) before selling them. The new restrictions are called for under a temporary emergency order that expires in 30 days.

For a refresher on why this is a big deal, here you go.

The traditional method for making money in the stock market is to "buy low and sell high." But there is another way to profit called "shorting," where the trick is to "sell high and buy low." There are strict rules when it comes to shorting stocks, however. One way they are broken is via naked shorting.

But first, let's discuss the right, as in legal, way to profit from a declining stock.

Investors short stocks that they believe are going to fall in price in the near future. To sell a stock short, you borrow the shares from your broker, then sell the shares and hold the money and wait for the stock to fall. If it does fall, you buy the shares at the lower price and give them back to your broker, who gets a commission and interest for his troubles.

If you short a stock whose price rises, things can get hairy. You can wait to see if the stock will decline, or you buy the stock back at a higher price than you sold them and give them back to your broker (along with the other fees), and take the loss. You can learn more about the short selling process here.

Upticked Off? Get Short With ETFs (Video, Apr. 3)

Jim Cramer is up in arms over the elimination of the uptick rule. But Michael Sapir, CEO of ProFunds, is offering another way for investors to short stocks.

To watch the video, click the player below:

Plus, don't miss these related videos on TheStreet.com TV: iShares CEO on Which ETFs Thrive in a Volatile Market (Aug. 27, 2007), Press Your Bets With Leveraged ETFs (Aug. 1, 2007), UltraShort ETFs a Smooth Play in Choppy Market (Jul. 27, 2007) and New ETF's Get Short & Ultra Short (Jan. 25, 2007).

Regulators have no problem with conventional short-sellers if the practice is done according to the rules. In fact, regulators are among the first to say that short selling provides a necessary check-and-balance on the market. Short-sellers, for instance, are particularly good at smoking out companies that are either engaged in fraud or misleading investors.

It's naked shorting, a manipulative practice that enables traders to defy the laws of supply and demand, that regulators are trying to stop.

In a naked short sale, a trader places short bets without actually borrowing the stock first or even determining that any shares are available to borrow. This way, the traders are freed from a key check of the short-sale process -- the need to find willing stock lenders. Critics claim such operations create excessive downward pressure on certain stocks and can create chaos as buyers await undeliverable shares.