Borrowing a security (or commodity futures contract) from a broker and selling it, with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker. Short selling (or "selling short") is a technique used by investors who try to profit from the falling price of a stock.

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For example, consider an investor who wants to sell short 100 shares of a company, believing it is overpriced and will fall. The investor's broker will borrow the shares from someone who owns them with the promise that the investor will return them later. The investor immediately sells the borrowed shares at the current market price. If the price of the shares drops, he/she "covers the short position" by buying back the shares, and his/her broker returns them to the lender.

The profit is the difference between the price at which the stock was sold and the cost to buy it back, minus commissions and expenses for borrowing the stock. But if the price of the shares increase, the potential losses are unlimited. The company's shares may go up and up, but at some point the investor has to replace the 100 shares he/she sold. In that case, the losses can mount without limit until the short position is covered.

For this reason, short selling is a very risky technique. SEC rules allow investors to sell short only on an uptick or a zero-plus tick, to prevent "pool operators" from driving down a stock price through heavy short-selling, then buying the shares for a large profit.

Example:

When I first started trading, shorting stocks seemed very foreign and scary. The concept of shorting was Little hard to grasp too. I have since learn how to embrace the idea and use it as an integral part of my trading strategy.

I will explain how shorting works with a very simple example. Everyone knows about the tickle me Elmo's and how popular they are. Around Christmas time these Elmo's can get very expensive as people bid the prices up on auctions.

Lets say you know that these Elmo's are going to lose their value in a few weeks. You ask your friend to let you borrow his. So now you haven't spent a single dollar and have procession of an Elmo. You quickly go out and sell the Elmo at market price for $100.

A week after Christmas the price of the Elmo's drop to $25 so you go to the store and buy one with the $100 you collected last week and give the Elmo back to your friend.

So let's review, you borrowed an Elmo sold it and pocketed $100 and bought it back for $25. You have $75 left which is your profit.

This is exactly how shorting stocks work. If you believe a stock is about to drop in price, you short it by selling it first and collecting the money. Once the price has dropped, you cover by buying the stock back and profit the difference.

Now let me explain why shorting is so dangerous. When you buy a stock the normal way and expect it to go up and it doesn't the most you can lose is all your money. If a stock is $5 and drops to zero you have lost all your money.

With shorting if a stock goes up you lose money. If a stock is $5 and goes to $10 you have lost all your money. If it goes to $20 you now owe your broker money. In theory a stock can go up forever so the losses can be unlimited.