Short selling is essentially a buy/sell transaction in reverse. The stock shares that the seller wishes to sell are borrowed from a broker, who sells the shares from the inventory on behalf of the person seeking to sell short.

Once the shares are sold, the money from the sale is credited to the account of the short seller. In effect, the broker has loaned the shares to the short seller. Eventually, the short sale must be closed by the seller buying an equal amount of shares with which to pay back the loan from his or her broker. This action is known as covering. The shares the seller buys back are returned to the broker, thus closing the transaction. The ideal situation for the seller occurs if the stock price drops and he or she can buy back the shares at a lower price than the short sell price.

Example of short selling

To illustrate the short selling process, consider the following example. A seller goes through a broker and requests to sell 10 shares of a stock current priced at $10 a share. The seller is credited with the $100 in proceeds from the sale. Assume that over the short term the stock drops to $5 a share. The seller uses $50 of that $100 to buy 10 shares to repay the broker with and close the transaction. The seller's remaining profit is $50. Of course, if the shares rise in price, forcing the short seller to purchase them at a higher price than the short sell price, the seller sustains a loss.

Although the amount of time a seller can hold onto the short sold shares before buying them back is typically indefinite, the seller must take into account interest charges by the broker on the margin account that is required for short selling.