I understand the concept of buying and selling stocks, ie you own a chunk of a company. What about short selling stocks? I understand what it does, you sell it at the first price then buy it at a later price, but what is the real world equivolent of this?
I’m not sure if this will help, but try thinking about it this way.
When you buy a stock in essence you are betting that it will go up. This is a gross oversimplification, but the seller who you are buying from is betting that the value of the stock will go down. (As I say, this is a gross oversimplification, because the seller might have all kinds of other reasons for selling: e.g. they need the money for something else, etc. but you get the general idea).
So, what do you do if you think the stock will go down? Well, one answer is, you just don’t buy it. But that doesn’t make you any money. You are better off finding someone else who thinks the value will go up, and entering into a deal with them. You say, look, I think the value will go down in a month. So, at the end of this month, I’ll sell you 100 shares at today’s price. If in the meantime the value drops $20 per share, then I make a tidy profit. I can buy the shares on the market, and then sell to you at the price we agreed upon. If the value goes up though, then I lose money, because I have to sell to you at a value lower than the market value.
So, why go through all this? Why let people bet that the value will go down? Because as discussed above, IN EVERY SALE, someone is betting that the stock will go down in value. The idea is that by making the market more liquid, i.e. by giving everybody the chance to structure their deals however they want, we are making a better, more efficient market.
Does that help?
Although Constatine’s answer is completely accurate, I don’t think it answers the question. I think that legally you are making a loan of the stock (from whom, well I would imagine a specialist, one whose job is to ensure an orderly market in the particular stock–as well as a few others). When you later cover your shorts, you are repaying the loan.
Hari is correct (well, taking out a loan rather than making one, but still). For individual investors, the party from whom a short-seller borrows the stock is from his brokerage firm. Where does the brokerage get the stock? From other customers. When a customer signs a margin agreement with a brokerage firm (allowing her to buy stock with money borrowed from the brokerage), she also agrees to allow the firm to lend the stock out to others without compensation to her. The brokerage then lends the stock to short-sellers in exchange for keeping the proceeds of the sale and earning interest on that amount.
Other investors may lend stock for a fee. A mutual fund or pension account, for example, can loan stock to brokerages or large banks (generally not directly to short-sellers) and collect the fee in the form of interest on the money being deposited. This interest can vary from stock to stock – for a big, liquid, easy to find stock, the interest is right around the short-term riskless rate. It can be much higher for less-liquid, harder to find stocks.
What’s the non-stock comparision? I can’t think of one that works directly except in the commodity markets, and even then we’re usually talking about future delivery, not current.
Of course there’s a real-world equivalent. On Day 1, Grocer #1 sells 100 jars o’
mayonnaise to a Buyer. Grocer #1 only has 2 jars in stock, so he says “I gotta get the rest from the back,” and he huffs and puffs his way to Grocer #2 down the street, who is insane and keeps hundreds of jars o’ mayonnaise in stock. Grocer #1 tells Grocer #2, “I gotta borrow 100 jars o’ mayonnaise; I give 'em back tomorrow.”
Breathless and out of breath - eh - Grocer #1 sells the 100 jars o’ mayonnaise for the princely sum of $1.00 each. On Day 2, a sudden glut on the world jar o’ mayonnaise market sends the price spiralling down to $0.50 a jar. Grocer #1 buys 100 jars at this price, and delivers them to Grocer #2, who was trembling with fear of a run on jars o’ mayonnaise, and him with only 300 jars. Grocer #2 is content and none the wiser, and Grocer #1 has $50 profit, over and above his usual profit on jars o’ mayonnaise.
Spec #1 hears that Grocer #1 is short 100 jars and so buys the other 900 jars from Grocer #2. Grocer #1 buys 100 jars from Spec#1 at $3 each to pay back Grocer #2. I like that better.
You’ve heard of “Buy low, sell high”, right?
In the case of short selling, it’s the exact same principle, just the order is reversed: “Sell high, buy low”.
Nametag, I don’t think that your example is really selling short, because selling short is when you sell something you don’t own, not something you do. After you sell short, you essentially have a negative amount of the stock. So if you own -100 shares of stock, and the price goes down $.20 a share, then you made 20 (-100*-.20=+$20).
Another way of thinking about it is that short selling is basically taking out a loan in which the amount loaned and the amount owed are expresssed in different terms. So if the current exchange rate is 2 dollars=1pound, then if I were to say “Okay, I’ll borrow $200, and I’ll then owe you 100 pounds”, then I would be selling pounds short.
In fact, every loan is essentially a short sell, since you are borrowing today’s dollars but owe tommorrow’s dollars.
As for the real world equivalent: what, you don’t consider Wall Street to be real? 
Suppose you see a bunch of people buying umbrellas for $20, and you’re convinced that in a few weeks the price will be down $10. You can tell people “Hey, it won’t start raining for while. How about you give me $15, and I’ll get you an umbrella when the rainy season starts.” The plan being that once the price drops to $10, you’ll buy up the unbrellas and deliver them. This would be selling umbrellas short.
When you buy (take a long position in) a stock, the worst that can happen is its value goes to zero and you lose your initial investment.
When you short sell a stock your losses are not limited (in theory they may be infinite) as the stock may double, triple, etc… in value. As the stock rises, you may have to set aside additional funds to cover the margin.
One of the most vicious (and yet somehow thrilling) tactics big traders use when they see a huge amount of shares shorted in a stock and start buying themselves. This action tends to raise the price of the stock causes many short-sellers to buy shares to cover their short position - again raising the price of the stock, forcing others to cover their shorts, and so on. Known as a “short-squeeze”, this shows why short-sellers need to have a stomach of iron. 
I tried to short Beanie Babies as an exercise in taking advantage of extraordinary popular delusions (though this was more of a madness of crowd thing). I emailed a few people who were bidding ridiculous prices for these things and told them I’d sell them a mint condition version of the one they want for 20% below the final price but that I wouldn’t deliver it for 2 years. People got too confused and I knew I was bending Ebay rules a bit so I just dropped it.
Uhhh, no. First of all, my Grocer does not own the mayonnaise he sold - he borrowed it. Short sellers borrow the shares they sell, but they’re still real shares changing hands.
The “negative amount of stock” is a silly way to look at it, although it might be good shorthand when keeping a ledger.
Ok just for the record which one of you guys answered the question?
After reading all that blabber I am quite confused.
WeAllDid, though NameTag, who is insane and keeps hundreds of jars of mayonnaise in stock, deserves a Kid Charlemagne beanie-baby for his clever fable and princely dialogue.
Skeptiko’s quick and dirty reply works nicely, too.
<anecdote>
Back in the 1990’s (when I traded shares on an almost daily basis) I had one day 1100 shares in a company (ALU) with an internet subsidiary in play. I sold them all at $11 per share. A day or so later, the stock is down to $9. I check my Suretrade portfolio and it shows I own (?) -400 shares that show a gain of about $800 . I call Suretrade up - they tell me I sold 1500 shares at $11. “I was only long 1100 shares” says I. “Yes, sir. That is true.” is pretty much the response I got."
I put a market order for 400 shares in and booked $800.
</anecdote>
What I don’t warrant a bolding?
Let me take a swing at a simple explanion.
Let’s say that you have a friend who comes to you and says
I would be willing to pay $10,000 for a 1920’s style death ray.
Now this guy is a friend, but not so good that it would bother you if you made a profit.
The problem is you don’t own any 1920’s style death rays right now, but you know where you can buy one for say $5,000.
So you tell your friend that you can supply a 1920’s style death ray for $10,000. He agrees to buy it. You go out and source it for $5,000 (ebay?, deathrays.com?)
You deliver the 1920’s style death ray and pocket 5K.
That is the essence of a short sale. You sell something that you don’t have for a price, betting that the price will go down, and when you have to deliver you will be able to purchase what you sold for less than you sold it for.
Rick that’s kind of a step backward. It’s missing the subtle nuance of actually handing over goods that you have borrowed rather than merely promising to deliver goods at a certain price in the future. Actually the difference really isn’t subtle come to think of it.
Real world example:
It’s July 4th and the liquor stores are closed. You find out that your neighbor’s party is out of whiskey. You open the cabinet and “borrow” your roommate’s handle. You take the handle over to the neighbor and predatorily sell it to him for $50. The next day you go the now-open liquor store, buy the equivalent handle for only $40 and put it back in your roommate’s cabinet. You pocket the $10.
This is an illustration of taking goods that you think can be bought for cheaper later and selling them today for a profit.