Recommended reading: The Pros and Cons of Short Selling Stocks by InvestorGuide.com
For example, consider an investor who wants to sell short 100 shares of a company, believing it is overpriced and will fall. The investor's broker will borrow the shares from someone who owns them with the promise that the investor will return them later. The investor immediately sells the borrowed shares at the current market price.
If the price of the shares drops, he/she "covers the short position" by buying back the shares, and his/her broker returns them to the lender. The profit is the difference between the price at which the stock was sold and the cost to buy it back, minus commissions and expenses for borrowing the stock.
But if the price of the shares increase, the potential losses are unlimited. The company's shares may go up and up, but at some point the investor has to replace the 100 shares he/she sold. In that case, the losses can mount without limit until the short position is covered.
For this reason, short selling is a very risky technique. For a while, SEC rules only allowed investors to sell short only on an uptick or a zero-plus tick, to prevent "pool operators" from driving down a stock price through heavy short-selling, then buying the shares for a large profit. This rule was eliminated in July 2007.