Most of you probably already understand the basic characteristics of 'short selling' and the account requirements for participating in that strategy. The technique is often maligned but it also occupies a necessary place in equity markets.

Short selling is an attempt to profit from a decline in the price of stock. An investor sells stock that is borrowed. If the stock falls below the original sale price, it is repurchased and returned to the broker as a replacement for the stock that was borrowed. The difference between the sale price and the purchase price is profit.

Short selling can be divided into two categories, declared and undeclared. Declared short selling is a common trading strategy that is used in the market regularly by institutional investors, fund managers and professional speculators. Because the basis for short selling is borrowed stock, declared short positions risk being squeezed. Recall that a short seller generally provides 50% of the value of the stock in a margin account. If the share price increases, the short seller will be forced to increase his margin collateral in order to maintain the short position. If the issue continues higher, the seller may elect to repurchase the stock instead of adding to his margin requirement. This contributes to the natural movement of the stock by increasing demand and thus driving the price higher.

Undeclared short selling is a destructive and unwelcome practice that leverages enormous negative pressure on a stock. The method consists of creating stock that doesn't exist to sell many times over. The stock isn't borrowed, it is actually fictitious stock that is sold short. This nonexistent stock increases a company's float and makes it very difficult for the stock price to increase in value. The short sellers make a profit at great cost to the companies involved. It adds massive costs to maintaining a market in a stock and it reduces a company's business options. It will also drive the price of a stock to artificial lows where eventual shareholder lawsuits can ruin the company's future.

Complaints to regulatory agencies haven't stopped the practice of undeclared short selling but one way a company can protect their stock is to recommend that shareholders take physical delivery of the stock certificates. When delivery of an issue is demanded by a significant number of investors, the originators of non-existent stock can be 'squeezed'. The short sellers won't have the stock to deliver and thus they will be forced to buy it in the open market. When this type of protective activity becomes public knowledge, unscrupulous traders will ply their ruinous techniques elsewhere.