Ask TheStreet: Naked Shorts

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

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.

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.