The SEC announced on July 30 that it was extending the ban on naked shorting of the stocks of companies with high exposure to mortgage debt.  This included Fannie Mae, Freddie Mac and 17 big investment banks.  Shorting is the practice of selling a stock short, i.e. borrowing shares to sell now in the hope that you can buy the stock to pay back later at a lower price.

For instance, if I think American Beanbag, which is selling at 10, is going to decline in value, I can borrow 100 shares for a week (for a small fee, of course), and sell them, pocketing the $1,000.  When I have to return the shares a week later, if the stock is trading at 5, I buy 100 shares, pay the $500 and book the $500 (minus the fee).

If, however, the stock goes up, say to 20, I’m on the hook for a $1,000 loss.  It’s buying low and selling high in reverse.

In naked shorting, everything works the same way, except that the person who wants to sell a stock short doesn’t actually bother to borrow the stock.  And among the people who enjoy this high-stakes game there are a few who don’t like to leave things to chance.  They sell the stock short (naked) and then set about making sure that it goes down.

All you have to do, especially in the world of small, lightly traded stocks, is to start a negative rumor about the company.  Among active traders, a little bit of bad buzz about a stock is enough to send them for the exits, which then leaves the naked short artist with a bargain basement price at which to fulfill the contract.

This technique is called “distort and short,” and it can be highly profitable for a trader who knows how to work the financial blogs and drop pearls of poison wisdom into the cups of volatile stocks.  If you read stories about the stock-trading legends of the past, you’ll probably run into more than one false rumor floated into the stock trading community with malice aforethought.

The pressure from this kind of market manipulation has only gotten worse with the advent of the Internet, which allows anonymous posting of just about anything on financial blogs and chat sites.  A good negative rumor can get around the Internet with astonishing speed.  As Mark Twain said: “A lie can travel halfway around the world while the truth is putting on its shoes.”

Or at least the saying is attributed to him.  But it could be a lie; after all, I found it on the Internet.