A ban on the short selling of financial shares — mainly banks, insurers and investment firms — was lifted yesterday. Many of us have heard of short selling, but what exactly is it, and can small investors profit from it?

In a nutshell, short selling is a way of profiting from a fall in a company’s share price. Many take the view that it is a fairly unethical practice; last September, Scotland’s first minister, Alex Salmond, attacked the short-selling spivs and speculators he blamed for targeting banking giant HBOS, while the Archbishop of York, the Right Rev John Sentamu, likened short sellers to bank robbers and asset strippers.

While the ban was in place, investors were not allowed to profit by selling financial shares that they had borrowed for a fee in the hope of buying them back for less at a later date.

The Financial Services Authority (FSA) has reserved the right to reinstate the ban on short selling without consultation if necessary, although its decision to lift it at all has been criticised. The Liberal Democrat Treasury spokesman Vince Cable says banks are different from other companies. If short selling results in a wave of panic that forces banks down, then taxpayers will have to assume responsibility.

Here, we answer your questions.

What exactly is short selling and how does it work?

While most popular with hedge fund managers, short selling can be used by any investor who believes a share is likely to go down in value.

When using this investment technique, a investor borrows an asset, such as shares, currencies or oil contracts, from another investor and then sells that asset in the relevant market, hoping that the price will fall. The aim is to buy back the asset at a lower price and return it to its owner, pocketing the difference on the way. But it is only possible for an investor to go short if there is another investor willing to bet that the shares or commodities will not fall as far as the short seller believes.

Why was the ban on short selling financial shares necessary?

The FSA banned investors from short selling bank stocks because the practice was creating problems for struggling institutions, notably HBOS, which almost collapsed as a result. That story ended with the bank being taken over by Lloyds TSB after its stock market value plummeted. The ban was intended to protect other vulnerable financial companies from suffering the same fate. A fall in the share price of many financial companies leading up to the lifting of the ban suggests the market is still worried about the strength of many companies. The trading outlook for the UK banks remains dreadful, which is no surprise when you consider the sliver of equity sandwiched between a deteriorating asset base on one side and significant liabilities on the other, says Jonathan Jackson at investment firm Killik & Co.

Why does short selling reduce share prices?

If lots of traders are short selling a particular share, then the first thing they will have to do is borrow the shares. Once they have done that, they can then sell them on, which pushes the share price down because there are more people trying to sell the stock than buy it. Fund managers who specialise in short selling can also cause market panic by selling lots of shares in a particular company as other shareholders become concerned that the share price will plunge.

How can I profit from short selling?

Hedge funds argue that short sellers are often pointing out an uncomfortable truth about the financial position of the companies whose shares they are selling: that they are not as valuable as people think they are.

They claim they can do others a favour by exposing the real value of a company’s shares.

One way to benefit from short selling is, therefore, to treat shares that are being borrowed in this way with a degree of caution.

There are a few ways to get involved in short selling. Perhaps the most common direct method is by taking out a contract for difference, which allows you to make money on share price movements without actually buying the shares through a stockbroker. The contract specifies the price of the shares at the start of the contract and the date on which it ends. It is basically an agreement to pay out cash on the difference between the starting and closing share prices.

Mark Dampier of financial adviser Hargreaves Lansdown says: Traditionally, the only way to benefit from a hunch that a stock was going to fall in price was to avoid it. Contracts for difference mean you can take a punt on this belief, which does open up another option for retail investors — although it is worth remembering you can lose out significantly if the stock goes up rather than down in price.

If this all sounds a bit scary, you can also gain exposure to short selling through an investment fund. Hedge funds themselves have had a fairly torrid time of late, what with high-profile scandals such as that involving US businessman Bernard Madoff, and many industry insiders believe more scalps will be claimed in 2009.

But one potentially appealing option in these volatile times is to invest in an absolute return fund that uses hedge fund tactics to try to ensure that investors receive a positive return, no matter what happens to the stockmarket.

Not all absolute return funds can do this, but those that can include Cazenove’s Absolute Target Return and BlackRock’s UK Absolute Alpha.