Perhaps you’ve read about the ban on short selling. Many believe it is one of the main causes of the current financial crisis and the fall of Bear Stearns, Lehman Brothers, and AIG. But what exactly is “short selling”? How and when can you do it? And why is it so frowned upon?

When to sell short. You sell short when you think that a certain stock price is going to fall, and you’d like to profit from that premonition.

How to sell short. Say you know something about a certain stock that nobody else does. Let’s use Apple. You were a tester for the new iPhone, which you found malfunctioned. You know that upon release of the phone tomorrow, Apple’s stock price will fall. You want to profit off of this, but you don’t own any AAPL shares. Or you do, but not as many as you’d like.

So you borrow AAPL stock from someone else’s account. Let’s call him Joe. Your broker can help you do this – take 100 AAPL shares out of his client, Joe’s, account (without Joe knowing about it) and give them to you. You sell those 100 shares at $140.90 each, today’s share price. The next day the new iPhone comes out, it bombs, and as you thought, shares fall to $100. (Dramatic, yes, but go with it). The next week, you think Apple’s share price will rise, so you buy back those 100 shares at $100 and give them back to Joe’s account. You’ve just made a sweet $4,090 in profit. To sum it up: you borrow shares of stock from someone else’s account. Sell them. Then buy them back at a (hopefully) lower price and return them to the account from which you borrowed.

Why sell short? One reason, as described above, is to speculate. If you think a stock or the market as a whole is overpriced, you can make money off of it. A second reason is to hedge – to protect yourself from unexpected losses. That is, if you’re long AAPL but want to take a little less risk, you might want to short another security in the computer industry, which includes risk inherent to Apple.

You probably shouldn’t sell short. Now I’m not recommending you actually do this, unless you are well versed in the markets. It’s pretty risky. If Joe decides he wants to do something with these shares, he can call you on it. At that moment you’ll have to cover, which means you’ll have to buy back the shares you borrowed from him and put them back into his account. So – say AAPL price actually rose and you were called when it was $160.90. Then you would have lost $2,000.

Even if you want to, right now you can’t. I also don’t recommend you do this, because right now you can’t. The SEC just put a ban on short-selling. After allegations that short sellers have led to the failures of Lehman, Bear, and the like, the SEC stepped in last Thursday and issued a temporary ban on short selling for 799 financial stocks. It’s alleged that short sellers often use false information and conspire to drive down the price of the stock.

This isn’t the first time we’ve placed a ban on short sellers. Short sellers were blamed for the Wall Street crash of 1929. Congress reacted by enacting a law, referred to as the “uptick rule,” which banned sellers from shorting during a downturn. Sellers could not short a share when the stock was selling for lower than the previous trade. This kept short sellers from adding downward momentum of a stock when it was already sharply declining. After almost 80 years, the ban was lifted in 2007, when the SEC determined the markets were orderly enough that they didn’t need the restriction (this is despite the fact that just two years prior in 2005, the SEC sought to restrict short-selling outright).

The history of short-selling takes us back earlier than the Great Depression, however. In 1609, Isaac Le Maire, a Dutch trader, made the first short. He was concerned about threats of attack by English ships and shorted shares of the Dutch East India Company, the first multinational corporation and the first company to issue stock. The Dutch stock exchange did not approve of Le Maire’s actions and temporarily banned short-selling.

Later, during the Dutch depression of the 1630s, speculators saw short-selling as a means to profit off of the economic downturn. The English reacted by banning short-selling completely.

Be sure to read more of what Diana learned today here.