I took an investments class as my last class before I graduated. In the class I finally began to understand how someone can short sell a stock, fundamentally.

As everyone knows, short selling a stock means that when the stock price goes down, you’re making money…basically. Whatever your reason for short selling; whether it be hedging the risk in your portfolio or you just have a feeling that a stock will fall sometime soon, there are a few things that — as an investor — you have to remember before you start entering into the market.

Here are three dangers that you have to watch out for if you’re short selling a stock that you wouldn’t have to look out for if you were to take a long position on a stock.

The Margin Call – Shorting a stock requires borrowing money. A brokerage often will happily loan an investor money, but if the shorted stock rises in value significantly, the brokerage will want the investor to add more cash to the account or sell some other stocks to compensate.

Infinite Downside – If an investor buys a stock and it falls to zero, all the investor loses is the initial money he or she paid. After all, the stock can’t go below zero. But on a shorted stock, there is, in theory, no limit to how much money an investor could lose, since a stock could keep rising and rising.

Wrong Timing – If an investor owns a share and the value goes down, he or she can always be patient and wait for the stock to rise. A short seller doesn’t have that option. If the stock price rises, the short seller might be forced to buy it back quickly. When many short sellers try to buy shares back at once, the stock’s price can zoom higher, creating a “short squeeze,” and short sellers can lose a lot of money very quickly.

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Federal regulators today made a rule permanent that was originally just an emergency rule that was meant to reduce abusive short selling during the stock market’s largest drops. The SEC announced that the action was targeting those who do “naked” short selling, which was expected to expire on Friday.

Regular short selling is basically when investors bet against a stock. They borrow a company’s shares, sell them, and buy them back when the stock falls and returns the stocks to the lender (and keep the difference in price). Naked short selling occurs when those sellers don’t borrow the shares before selling them and just look into covering their positions after the sale has occurred.

The SEC emergency rule includes a requirement that the brokers have to buy or borrow securities to actually deliver during a short sale. They have also been considering several new ways to rein in the rush of regular short sellers that have been trying to cash in on the fall in stock prices.

The five SEC commissioners voted in April to put forward for public comment five alternative short-selling plans. One option is restoring a Depression-era rule that prohibits short sellers from making their trades until a stock ticks at least one penny above its previous trading price. The goal of the so-called uptick rule is to prevent selling sprees that feed upon themselves — actions that battered the stocks of banks and other companies over the last year.

Another way to stop the increase in short sellers would be to ban short selling for the remainder of the trading session when a stock declines 10% or more.

The SEC and their staff are working with stock exchanges to make short sale data and volume publicaly available through the websites of the exchanges. This should result in an increase of the amount of information currently required according to the SEC.

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Short selling isn’t bad. It’s a good way to recover losses or gain an opportunity in the market. Short sellers have a bad reputation. Short selling can be likened to betting against the team you think will lose the World Series. Short sellers sometimes do better than those who only long stocks.

Short sellers’ bad reputation keeps some investors from shorting the stocks, and many find that bull markets are more the long term norm. There are fewer short sellers than those who buy a stock long because shorting can be risky and volatile when compared to buying stocks. Also, there aren’t as many short sellers because the investor can lose infinitely when it comes to the price of the stock going up, it makes it very expensive to buy shares to “cover a short position and create losses far in excess of the original investment.”

When done intelligently, shorting can be enormously lucrative. Just consider the trading record of Short Alert, a small North Carolina-based research firm that has been producing reports recommending stocks to short since 1998. In the 10½ years ended June 30 of this year, about 75% of the 86 recommendations it made would have turned a profit, even if they were judged based on the conservative criteria used by Barron’s in examining Short Alert’s record. In other words, the firm offers an excellent window on how to pick stocks to sell short.

Barron’s found that the firm, led by managing partners Nat Guild and the ironically named Michael Long, produced annual returns averaging 18.3% from 1999 through 2008. If the period studied is stretched through the end of June, the annual returns jump to 20.3%. But beware: Short selling isn’t always a route to easy money: 2004 would have produced a terrible loss of 37%, followed by three years in a row of 13% losses.

In judging Short Alert, Barron’s tracked the short positions for a year after they were implemented. Thus, the most recent of the 86 reports we reviewed is dated June 19, 2008.

Here are 5 recommendations from SmartMoney to short:

JCOM
MIDD
CMP
K12
PTV

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The uptick rule was eliminated by the SEC in 2007. It required short sellers to sell their shares at a price above a stock’s most recent trading price.

When someone short sells a stock, they are borrowing a company’s shares, selling them, and buying them when the stock falls. They then give the stock back to the lender while keeping the price difference.

If a company stock was trading at $50 and a trader anticipated that it would decline, he could borrow shares but couldn’t sell them until after the stock traded higher, or “ticked up,” to at least $50.01.

Schapiro said that many investors who include both individuals and large financial institutions are behind a measure to reinstate the rule.