A. I. Houriani's  Instablog

The process of short selling is actually quite screwed up. The person owning the shares is actually never informed that his shares have been short sold. The whole process of short selling is transacted through a third part (a broker) who lends a short seller some shares to sell in the market.

Excessive short selling can be quite destructive to a stock's price though, as we've seen with Skullcandy. To elaborate on how this works, let me give an example:

Lets say company xyz has issued 1,000,000 shares in the market. I believe this company is extremely valuable so I go and buy up all their shares. So, at this point, there are a total of shares 1,000,000 shares; however, I'm holding all 1,000,000 of them, so market supply is 0. Lets say person B comes along and short sells all 1,000,000 shares. What happens at this point is my brokerage firm transfers my 1,000,000 shares to him (without my knowledge) and person B dumps them in the market.

What has just happened is VERY important. Because person B just shorted shares that weren't his, he has just artificially created more shares in the market. Now there are 2,000,000 shares in the market (1,000,000 shares that I bought + 1,000,000 shares that were resold to the market). In order for the market to absorb all these shares, it requires much more purchasing power; however, with the supply of shares doubling (while demand remaining constant), the price drops (law of supply and demand).

So now, because person B over-saturated the market with shares, he caused the price to drop. Eventually though, he'll be forced to buy-to-cover under a few scenarios:
1) If I chose to sell my shares, person B will be forced to buy back all the shares in the market (at whatever the price is) to give me back my shares
2) If the stock price goes up too much, person B may receive a margin call, forcing him to buy back all the shares (regardless of the price/loss)
3) To capture gains/losses

What we know is this: even though the stock will severely under-perform the market, those who short sold the stock will be forced to buy back their shares if they ever want to capture their gains or if they're forced to by their broker. In the long term, severely short selling a stock (like with Skullcandy) is unsustainable.

Disclosure: I am long SKUL, AAPL, AIG.