Most investors buy stocks hoping the price will go up. They follow the classic wisdom: buy low, sell high. Short selling flips this on its head. It’s a strategy for profiting when a stock's price goes down. The mantra for short sellers is: sell high, buy low.

Instead of buying shares, a short seller borrows them from a broker and immediately sells them on the open market. The goal is to wait for the stock's price to fall, buy the shares back at the new, lower price, and then return the borrowed shares to the broker. The profit is the difference between the initial sale price and the buyback price, minus any fees.

To short a stock, you first need a special type of brokerage account called a margin account. This account allows you to borrow money or securities from your broker. Once you have one, the process looks like this:

Let's use an example. Imagine you think shares of Company XYZ, currently trading at $50, are overvalued and will fall. You decide to short 100 shares.

Of course, this is a simplified view. As a short seller, you have obligations. If the company pays a dividend while you have an open short position, you must pay that dividend to the person or entity you borrowed the shares from. You also pay interest to your broker on the value of the borrowed shares for as long as your position is open.

Short selling is not for the faint of heart. The risks are significant and very different from the risks of buying a stock.

When you buy a stock, the most you can lose is the money you invested. If you buy 100 shares for $5,000, your maximum loss is $5,000 if the company goes bankrupt and the stock price drops to zero. Your potential gain, however, is theoretically unlimited, as the stock price can climb indefinitely.

Your maximum profit occurs if the company goes bankrupt and its stock price falls to zero. In our example, you'd sell at $50 and wouldn't have to buy anything back, pocketing the full $5,000 (minus fees). But what happens if you're wrong and the price goes up? If XYZ stock rises to $70, you'd have to spend $7,000 to buy back the shares you sold for $5,000, resulting in a $2,000 loss. If it goes to $100, you lose $5,000. If it keeps rising, so do your losses. There's no ceiling.

This leads to another risk: the margin call. Because you're borrowing, your broker requires you to keep a certain amount of collateral (cash or other securities) in your margin account. If the shorted stock rises sharply, your potential losses increase, and your collateral may no longer be sufficient. When this happens, the broker issues a margin call, demanding that you either deposit more funds or close your position by buying back the shares at a significant loss.

Now that you understand the fundamentals, let's test your knowledge.

Understanding these mechanics is key to seeing how certain market situations can unfold.