[notafraudster]

When you buy a stock, you pay money and someone else gives you a stock. Once you have it, you can hold it for as long as you want. Its value can go up or down. When you sell, you get money, which might be less or more than what you paid. If the value goes to zero, you can no longer sell and you will never get any money.

When you short a stock, you are basically selling a stock you don't have. Thus you get money and owe someone else a stock (in practice what happens is someone else unknowingly gives you a stock for free and then you sell it, and they get an IOU for a share of the stock later; but let's not worry too much about the mechanics). Once you have this IOU, you can hold on. The value of the liability associated with the IOU can go up or down. If it goes down, then when you discharge that liability by buying the share you owe, you will pay less than you were paid for the short, thus making a profit. If it goes up, then you will pay more and thus lose money. One risk with a short is that your liability is unbounded. In a traditional stock purchase, the worst that can happen is that you lose the money you put in. In a short sale, you can lose many multiples of the money you put in if the stock does very well. Under a few circumstances, the IOU can be called, forcing you to prove that you have the money to buy a share; for instance, if you were to short $1,000,000 in shares and the share price triples, you owe $3,000,000.

To summarize: when you buy a stock, it's because you think it will be worth more later (again, let's set aside dividends and other things). When you short a stock, it's because you think it will be worth less later.

The reason shorting is permitted is because in general, there is a belief (mistaken or not), that additional liquidity -- more trading -- benefits everyone involved in a market by reducing the spread between prices for buying and selling; additionally, shorting makes it possible to hedge your exposure to a sector (i.e. to trade off some upside in a sector with some corresponding downside and vice versa).

[kklisura]

Thanks for the explanation! What happens when someone shorts a stock and then the company goes under? In this case of SVB, you short a stock, company gets taken by FDIC, trading is halted and I'm assuming the company will be sold/dissolved? So what happens with the shorts?

Edit: Answered already by someone in other thread https://news.ycombinator.com/item?id=35107107

[gmiller123456]

At that point, the stock is worthless and the borrower doesn't have to return it. They keep all of the money from the initial sale.

[eru]

It's a bit more complicated.

Companies are often in limbo for a long time before they officially go under.

The borrower has to keep paying borrow costs during that time. Which makes shorting companies that go down rather risky.

[eru]

> (in practice what happens is someone else unknowingly gives you a stock for free and then you sell it, and they get an IOU for a share of the stock later; but let's not worry too much about the mechanics)

That's a mis-characterisation. What makes you think the counterparty lends you the stock unknowingly?

> The reason shorting is permitted is because [...]

You forgot the most important reasons:

First, why forbid voluntary transactions between people? Stock lending is an activity between consenting adults.

Second, short selling is a way to finance muckracking and investigations. Short sellers are the only people with an incentive to burst manias. They are an important mechanism for the market to regulate itself.

[eadmund]

> someone else unknowingly gives you a stock for free and then you sell it

Lends it for a fee, right?

[eru]

Also not 'unknowingly'.

[junon]

This is the clearest explanation I've ever read of this. Thank you.

[eru]

Alas, it's also not quite right.

Eg 'in practice what happens is someone else unknowingly gives you a stock for free':

Someone else willingly and _knowingly_ loans you the stock, and _charges_ borrow costs. As a private investor you can participate in stock lending, just check with your broker. Index funds are often more than happy to loan out their shares, partially because it's one of the few ways they have to make extra money.

(Also maybe partially because it helps offset their impact on the market. If a new company makes it into the S&P 500 and all of a sudden index funds have to own 20% of that company, you might expect prices to go up in _anticipation_, ie before the index fund can buy. But if at the same time the same 20% of that company's stock becomes available for loan and thus short-selling, that might help counteract this move.)

See good old Wikipedia https://en.wikipedia.org/wiki/Short_(finance) for more.