This article is from the Investing Articles: Stocks and Options series.
The short sale of stock is a bet that the price of that stock will decline. Here are the mechanics. You decide that XYZ at a price of $110 is at or near its peak. You feel that XYZ will decline in price from this level. So you want to short the stock. You tell your broker you want to short 100 shares of XYZ at 110. You borrow from your broker 100 shares of XYZ at $110 and sell it to someone else.
This is the nature of the short sale. You're selling something which you borrowed. Again, you borrowed 100 shares of XYZ at $110 and sold it to someone else. You actually borrowed the 100 shares of XYZ from your stockbroker. He either has it in inventory or he borrowed it from a client or another brokerage firm. Either way, it is your broker who loans you the stock to sell to someone else.
The potential loss on the short sale of stock is unlimited. This is because a stock can theoretically rise infinitely. Therefore, to protect himself, the short seller should always use a 'buy stop' order GTC (Good Till Canceled). The investor might decide that if the price of XYZ rises $5 he wants to get out of the position. He would place a buy stop order at $90. Then, if the price of XYZ rises to 90, he is assured that he will get out at about 90. Remember, a stop order becomes a market order when hit. Therefore, there is no guarantee that he will get out exactly at 90. But he will get out at 90 or about 90. One can also place a limit order when he wants to get out of a short position which went up. This will get him out at exactly that price. However, there is no guarantee that the trader will get out. He could miss the market.