Ask TheStreet: Naked Shorts

Left unchecked, naked shorting can lead to an irregular situation in which the total number of shares sold short on a stock exceeds its float, or the number of shares available for trading.

The issue of just how widespread naked shorting is on Wall Street is a matter of considerable dispute, despite the regulatory crackdown. Some contend the unsavory practice has all but disappeared since the National Association of Securities Dealers and the Securities and Exchange Commission instituted new rules in early 2005 making it more difficult to engage in naked shorting. The rules, commonly referred to as Regulation SHO, prohibit brokers from letting traders short a stock unless there are "reasonable grounds" for believing there are shares available to borrow.

The most outspoken critics of naked shorting say it remains a rampant practice among a group of nefarious short-sellers and brokers.

Short-sellers point out, however, that many of the companies often cited as victims of naked shorting are businesses that were either losing money or had failed business strategies.

Also, naked shorting can be difficult to prove because trades settle in three days. So technically, short-sellers have three days to locate the shares before the trade is overdue. And even under the new rules, the regulators won't really start digging too deeply until five days after the initial sale.

Finally, it's hard to prove naked short selling in some cases because it's not always done with illegal intent. Occasionally, there are legitimate reasons why shares are not delivered in time. Sometimes there are mistakes in transferring physical certificates, and those cases are usually resolved in a week or two. And sometimes traders just make mistakes by selling stocks that they think they have in their portfolio, but really don't, thus causing an imbalance.