Shorting a stock is also called ‘selling short’. You are selling first, buying later. When you sell short, you are basically borrowing shares of a company and selling them at the current market price. Your plan is that the share price is going to fall. If they do fall, the shares can be bought back at a lower price with the difference between the sell price and the buy back price being the profit on the play. Using your example, to short 100 shares of a $5.00 stock, a short sale order is entered with a broker, who has (or may not have) stock available to borrow for short sales (you can ask that shares you own in a stock not be sold short, something VERY important with the new dividend taxation laws). The stock is then sold pursuant to your short sale order. Short sale rules require short sales to be made on an uptick; in other words, you cannot step in when the stock is in a freefall. You will have to return the shares, but first you wait for the price on the stock to fall. It begins to drop and finally hits $2.00 a share and you think that’s as far as it will go, so at this point you buy back the 100 shares for $200. You turn the stock back over to the broker, but pocket the difference between the sell price and the buy back price ($500 – $200). Your profit is $300. It is the same as buying low and selling high, just doing it in reverse order.
Short selling has unlimited risk in that the stock can keep rising and rising. Thus unless you exhibit experience to your broker you may not be able to do it. Add on to that the fact that downside action can be rapid and volatile, and if you can’t keep a keen eye on a short position like this it could get away from you quickly. However, educated (and unemotional) investors can take what the market gives, and short selling on stocks without option chains can be profitable in an established downtrend. We prefer to do that (playing the downside in this case) by buying puts. With puts, our risk is defined and limited to the amount invested, and no more.