It moves up and down to find the line between the words you know and the ones you do not. You see exactly where your vocabulary starts to break down.
Does it count how many words I know?
It looks for the boundary rather than a count. "Where do I stop knowing them" is more useful for choosing what to learn next than "how many do I know".
Will lucky guesses inflate the result?
The test crosses the boundary several times, so one or two lucky guesses are corrected within a few questions.