Most of us are familiar with the idea of being able to buy and then sell a share, normally this is referred to as going ‘long’ in other words you feel it is a good share and you want to hold on to it. The opposite of this is where you sell and then buy which is going ‘short’, in other words you don’t think the stock is good and you don’t want to hold on to it so you borrow it and sell it today, buy it tomorrow (and dispose again to the original owner) and your position is set by the difference.
In a short sale a drop in the price makes you money because (for instance) if you sold today at $3.00 and bought back at $2.80 then you made 20c per share. If however, the price goes up to say $3.20 then you have to make up the difference. This is before we get into other areas like options or any derivatives. An easy way to understand it is this: the tide comes in and out (shares go up and down) you can place your bets that it will come in or out, if you understand that then you can understand short selling, you are trading based on the direction of the movement and just because something is dropping in value doesn’t mean you can’t trade on the position of it.
At times short sellers are demonized and recently short selling was banned on many of the banks and financial institutions. However, short selling is a natural part of the market and often companies that are blaming short attacks have stock prices that drop even when short selling is banned – unfortunately fundamentals still matter.
Naked short selling on the other hand is a different issue and this is a short sale entered into without having borrowed the stock first. This was banned by the SEC and to be fair, it is not a positive market practice as it means the number of short sales are not even relevant to issued share capital.
Short sellers do have a place in the market, they are the counter culture of ‘irrational exuberence’, you can legitimately hedge your position by shorting stocks, hedgefunds exist on the basis of going long and short, short sellers put liquidity into the market and some investors short stocks they own as a way of crystalizing gains if they fear the share price may drop. Short selling is a component of efficient markets, removing it won’t fix the problems with financial companies, short sellers didn’t create the issues so you can’t solve them via short sellers either.