Short selling stocks is a method of betting against a stock. You borrow stocks from your broker and sell them a view to buying them back at a lower price. Short sellers hope to profit from market declines, or when a stock is hit with unexpected bad news leading to a tanking of the share price.
The mechanics are rather simple. You borrow the shares from your broker, for which you pay a financing fee, and return them when you them back at a lower price. For example, if you get news that stock XX is suffering from sharply lower customer orders and is currently trading at $50, you can sell 200 shares at $10,000. Two months later, you buy them back at $25.00 and pocket a gross profit of $$5,000, for a hefty 50% return.
Short selling is a short-term strategy that works best when the broader market is in decline. In 2008, any investor who shorted the banks would have done very well. However, this strategy requires monitoring prices closely so as not to be caught out by a reversal of trend. In an improving market, the headwinds are against short selling.
Your profits are limited to what you receive from the short sale, and these profits are subject to income tax, but the prospect for losses are pretty steep as a stock can fall to zero.
The SEC has in July 2009 permanently banned “naked” short selling where the investor looks to cover the stock only after the sale, to stop wild swings and market turbulence. Now the transaction broker has to promptly buy or borrow the stock. Stopping the abuse of short selling is a an announced SEC priority, and it is considering other rules including more public disclosure of short trades.
One of these is the Depression-era uptick rule which prevents short selling until the stock ticks at least 1 cent above the previous trading price.