Here's an example of short selling in one of its purest forms:
Say, Fred is a tomato farmer... Fred makes a living by producing and selling tomatoes to the market in any given year.
Well, then comes a year when Fred's whole tomato plantation is struck by disease and rot to nothing.
In such a scenario, Fred'll go broke, he produced nothing and therefore can sell nothing. Is that really fair? So what the hell can Fred do in such a year?
Yes, Fred can go short sell the tomato market, Fred is gonna go sell tomatoes that he doesn't own. So, how does this work? one way is, Fred can go to the neighbouring farms of Bob, Mary, Bill, John and Harry; and ask if he can borrow some of their product. Say, each agree to lend Fred 10% of their produce (a total of 50%). That 50% Fred can now sell onto the market and realise the cash proceeds made from the sale.
The next year is fair, and Fred produces his yearly portion of tomatoes. Now 50% of that he'd return to the other farmers (essentially buy back his short position), and the other 50% he'd sell onto the market.
Without the short selling Fred's year on year sales, assuming prices are stable or fixed, would look like: 100, 100, 0, 100, 100 (that 0 year may be painful and wipe him out).
With short selling: 100, 100, 50, 50, 100 (that is, he's averaged out his sales to cope for the bad year).
In an environment where market prices fluctuate, say for the duration of Fred's short position the market price for tomatoes were to fall, he'd realise a gain above the 50, 50 (and the other farmers would in total lose the difference). Just as if the market price were to rise, he'd realise a gain below the 50, 50 (and the other farmers would in total gain the difference).
These days, any investor can join the long and short side of this transaction. Oh ooops sorry Freddy ole pal, I've just been banned from taking your side.
