A less publicized and more sinister version of short selling can take place on Wall Street. It's called "short and distort" (S&D).

Nothing is inherently wrong with short selling, which is permissible under the regulations of the Securities and Exchange Commission (SEC). However, the short-and-distort type of short seller uses misinformation and a bear market to manipulate stocks. S&D is illegal, as is its counterpart, the pump and dump, which is mainly used in a bull market.

It is important for investors to be aware of the dangers of S&D and to know how to protect themselves.

The Difference Between Short Selling and Short and Distort

Short selling is the practice of selling borrowed stock in the hope that the stock price will soon fall, allowing the short seller to buy it back for a profit. The SEC has made it a legal activity for several good reasons. First, it provides the markets with more information. Shorters often undertake extensive and legitimate due diligence to discover facts and flaws that support their suspicion that the target company is overvalued.  Short selling also provides investors who own the stock (i.e., have long positions) with the ability to generate extra income by lending their shares to the shorts. (For background reading, see the Short Selling tutorial.)

Short-and-Distort Traders Manipulate With Smears

S&D traders, on the other hand, manipulate stock prices in a bear market by taking short positions and then using a smear campaign to drive down the price of the targeted stock. This is the inverse of the pump-and-dump tactic, whereby an investor buy stocks (take a long position) and issues false information that causes the target stock's price to increase.

Generally, it is easier to manipulate stocks to go down in a bear market and up in a bull market. The pump-and-dump is perhaps better known than the short-and-distort because of the long bull market and the media. For example, the stock market had been in a general uptrend in the early to mid-1980s, which provided ample fodder for "pumpers." Movies like "Wall Street" (1987) and "Boiler Room" (2000) helped educate investors about the risk of this type of stock manipulation. (To read more about stock market movies, see Financial Careers According To Hollywood.)

Short-and-distorters try to profit by stimulating fear, but this only works if they have credibility. Therefore, they will often use screen names and email addresses that imply they are associated with the SEC or the Financial Industry Regulatory Authority (FINRA). Their goal is to convince investors that every proponent of the stock has ties to the company and that the SEC is watching and will halt the stock. S&Ds also intimate that they are looking out for investors' interests.

Short-and-distort players clutter message boards, so optimistic information cannot easily be found. "Get out before it all comes crashing down" and "Investors who wish to enter a class action lawsuit can contact …" are typical posts, as are their projections of $0 stock prices and 100% losses. If their strategy is suspected by longs, they attack the person who has caught them. In other words, the market manipulator will do everything in his or her power to keep buyers out of the stock and keep the price heading south.

The Net Effect of Short and Distort

When a short-and-distort maneuver succeeds, investors who initially bought stock at higher prices sell at low prices because of their mistaken belief that the stock is worthless, caused by an effective distortion campaign. At the same time, the S&Ds cover at low prices and lock in their gains.

In the uncertainty following some prominent bankruptcies such as Enron in 2001 or Nortel in 2009, investors were more susceptible to this type of manipulation on other stocks than they were likely to be during prosperous periods. During downturns, the first appearance of impropriety could easily cause investors to run for the hills. As a result, many innocent, legitimate and growing companies are at risk of getting burned, and some investors along with them. (See also: How to Profit From Panic Selling.)

Identifying and Preventing Short and Distort

Here are some tips for avoiding being burned by a short-and-distort scheme:

  1. Do not believe everything you read—verify the facts.
  2. Do your own due diligence and discuss it with your broker. (See also: Due Diligence In 10 Easy Steps.)
  3. Hypothecate your stock—take it out of its street name to prevent short sellers from borrowing and selling it.

The best way to protect yourself is to do your own research. Many stocks with great potential are ignored by Wall Street. By doing your own homework, you should feel much more secure in your decisions. And, even if the S&Ds attack your stock, you will be better able to detect their distortions and be less likely to fall prey to them by selling the stock at a loss.

How to Identify Good Research

Ask yourself these questions to spot the key characteristics of a good research report:

1. Is there a disclaimer?

The SEC requires that everyone providing investment information or advice fully disclose the nature of the relationship between the information provider (the research analyst) and the company that is the subject of the report. If there is no disclaimer, investors should disregard the report. (See also: What Disclosures Mean in Plain English.)

2. What is the nature of the relationship?

Investors can get good information from pieces published by investor relations firms, brokerage houses and independent research companies. Using all of these sources will provide information and perspectives that can help you make better investing decisions. However, you need to evaluate their conclusions in light of the compensation (if any) that the information provider received for the report.

Can a Wall Street analyst who is even partially compensated by trading generated by the report be more objective than a fee-based research firm that is paid a flat monthly rate with no performance bonus? The answer to this question is left for each investor to decide, but both types of reports are typically available to use for evaluating a potential investment. The nature of the compensation will provide information to help you evaluate a report's objectivity.

3. Is the author identified and contact information provided?

Generally speaking, if the author's name and contact information are on the report, it is a good sign because it shows that the author is proud of the report and provides investors with a way to contact the author for additional information.

Research reports from legitimate brokerage firms post the author's name and contact information near the top of the front page. If the author's name is not given, investors should be very skeptical of the report's contents.

4. What are the author's credentials?

Letters after a name do not necessarily mean that the author of the report is a better analyst, but they do indicate that the analyst has undertaken additional studies to expand his or her knowledge of finance and investing. (See also: The Alphabet Soup of Financial Certifications.)

5. How does the report read?

If the report contains grandiose words and exclamation points, beware. This not to say that good analysts are boring, but good reports don't read like a tabloid headline. A reputable analyst would never use exaggerations like "sure things" or "rockets" and would never suggest that you mortgage your home to buy a stock.

Objective research reports provide reasoned arguments to buy or sell a stock. Key factors such as management expertise, competitive advantages and cash flows are cited as evidence to support the recommendation. (See also: Research Report Red Flags.)

6. Is there an earnings model and target price with reasonable assumptions?

The bottom line for any recommendation is the earnings model and target price. The assumptions upon which the earnings model is based should be clearly stated so the reader can evaluate whether the assumptions are reasonable. The target price should be based on valuation metrics—such as the price-to-earnings (P/E) or price-to-book (P/B) ratio—that are also based on reasonable assumptions. If a report lacks these details, it is generally safe to assume that the report lacks a sound basis, and should be ignored. (See also: Financial Ratio Tutorial.)

7. Is there ongoing research coverage?

A commitment to providing ongoing research coverage (at least one report per quarter for at least one year) indicates that there is a solid belief in the company's fundamental strengths. It takes a lot of resources to provide this type of coverage, so a firm providing ongoing coverage is a sign that it legitimately believes in the long-term potential of a stock.

This contrasts with one-time reports that are used to manipulate stocks. In these cases, supposed research firms will suddenly issue "reports" on stocks they have never reported on before. Generally, these reports can be identified as an attempt at stock manipulation because they will not contain the attributes of a legitimate research report, as discussed above.

The Bottom Line

Unscrupulous S&D tactics can leave investors holding the bag. Fortunately, high-quality stock reports are relatively easy to spot, and needn't be confused with stock manipulators' dramatic claims. Keep your cool when analyzing a stock, and avoid getting caught up in online hype. By analyzing potential investments carefully and objectively, you can protect yourself from falling prey to S&D players—and make better stock picks overall.