What does short selling stocks mean? The secret to making money even when the market falls

There is a saying in the investment circle: “Only those who can short are true investors.” While this statement may be a bit exaggerated, it highlights the importance of short selling in trading. Unlike going long, short selling is a strategy to profit from market declines, changing the traditional perception that “only rising prices can make money.”

What is the essence of stock short selling?

Stock short selling, also called shorting, is based on a simple logic: predicting the market will fall, sell first and buy later to profit from the price difference.

Specifically, the full process of short selling is:

• Borrow stocks you do not own and sell them at the current price (opening position)
• Wait for the stock price to decline
• Buy back the stocks at a lower price
• Return the stocks to the lender, and the difference is your profit

Unlike going long, which requires buying first and selling later, short selling reverses the order of transactions. This counterintuitive approach allows investors to find opportunities even in a bear market.

Why does the market need a short selling mechanism?

Many people ask: why does the market allow short selling? There are deep economic reasons behind this.

If the market could only go long, investors’ profit methods would be severely limited. This could lead to:

• Rapid surges during rallies, forming bubbles
• Sharp drops during declines, causing high volatility
• Reduced market participation and liquidity shortages

Markets that permit short selling enable the forces of bulls and bears to balance:

Hedging risks: When you hold a stock but worry about short-term declines, you can short to offset potential losses.

Suppressing bubbles: Short sellers target stocks that are seriously overvalued, helping to maintain rational pricing.

Enhancing liquidity: Regardless of market direction, investors have opportunities to profit, which naturally boosts market activity.

How to operate stock short selling? Three mainstream methods

Method 1: Margin short selling (margin trading)

This is the most traditional way. You borrow stocks from a broker and follow these steps:

Process:

1. Open a margin trading account (meeting certain capital requirements)
2. Submit a short selling application
3. Borrow the target stocks and sell them
4. Wait for an appropriate time to buy back
5. Return the stocks to the broker

The downside is that the threshold is relatively high; different brokers have different minimum asset requirements, generally above $2,000. You also need to pay the broker’s borrowing fees.

Method 2: CFD (Contract for Difference) short selling

CFDs have become popular in recent years as a short selling tool. They are financial derivatives that replicate the price movements of the underlying asset.

Advantages of CFDs over traditional stock shorting:

Example: Shorting Google stock with CFDs requires only $434 margin (20x leverage) to control a position worth $8,687. Using margin trading, the initial capital needed would be $4,343.

Method 3: Shorting via futures

Futures are another tool for short selling, similar in principle to CFDs but with their own features:

Futures specifics:

• Contracts have fixed expiration and delivery dates
• Less flexible than CFDs
• Usually require higher margin
• Require strong professional knowledge and practical experience
• May involve physical delivery

Individual investors are generally not advised to trade futures directly for shorting due to high risk and delivery considerations.

Practical example: How to profit from shorting stocks

Let’s demonstrate the entire process with a real example.

Tesla stock shorting case:

In November 2021, Tesla hit a historic high of $1243. In 2022, the stock rebounded but technical analysis showed it struggled to break previous highs.

Suppose you shorted when the stock attempted a second breakout on January 4:

1. Open position: Borrow 1 share of Tesla and sell at $1200
2. Hold: Your account now has $1200 cash
3. Close position: One week later, the stock drops to $980; buy back 1 share
4. Settlement: Selling price $1200 - buying price $980 = $220 profit

If you consider broker interest and transaction fees, the actual profit might be slightly less, but the principle remains the same.

How shorting forex works

Shorting forex is essentially the same as shorting stocks, but the trading object is currency pairs.

Basic principle:

• When you expect a currency pair (e.g., GBP/USD) to depreciate
• First sell the pair
• Wait for the exchange rate to fall
• Buy back at a lower rate
• Capture the price difference as profit

Real case: A trader used $590 margin with 200x leverage to short 1 lot of GBP/USD on a 5-minute chart at 1.18039. When the rate dropped 21 pips to 1.17796, they gained $219, a 37% return.

High leverage can bring significant gains, but also enormous risks. Exchange rates are influenced by many factors: interest rate changes, trade balances, foreign reserves, inflation expectations, macro policies, etc. Professional analysis is essential.

Core risks of stock short selling

Forced liquidation risk

Shorted stocks are borrowed from brokers; ownership remains with the broker. The broker has the right to forcibly sell your position during market declines or margin shortfalls. This could force you to realize losses at the worst possible moment.

Unlimited loss risk

This is the most deadly risk of short selling.

Understanding the difference:

• Long position: Losses are limited; if you buy 100 shares at $10, the maximum loss is $1000 if the stock drops to $0.
• Short position: Losses are potentially unlimited; if you short 100 shares at $10, and the price rises to $100, you lose $9000. If it continues rising, losses can be infinite.

This fundamental difference makes short selling riskier than going long.

Judgment error risk

Profiting from shorting depends on correctly predicting market direction. If your judgment is wrong and the stock price rises instead of falling, losses can escalate rapidly.

Proper ways to use short selling

1. Short-term trading is preferable to long-term

Short selling is not suitable for long-term holding because:

• The longer you hold, the higher the risk of forced liquidation
• Continuous payment of borrowing fees
• Brokers may recall borrowed stocks at any time

Short selling should be a quick, tactical move.

2. Control your position size

Even if your judgment is correct, do not make short selling your main investment strategy. Recommendations:

• Keep short positions to no more than 20-30% of total capital
• Mainly use for hedging long positions
• Avoid frequent position additions

3. Strict stop-loss discipline

The biggest mistake in short selling is “holding on to losses.” Set clear stop-loss points, such as:

• Close the position if losses reach 5%-10% of initial capital
• Do not add to losing positions in hopes of a reversal
• Take profits promptly and avoid greed

Summary

Stock short selling is a double-edged sword. It provides a tool for profiting in bear markets and enriches investment strategies. But due to the risk of unlimited losses, it requires higher professional skills.

The key is to recognize: short selling is not a primary investment activity but a risk management tool. Smart investors use it to hedge risks and seize opportunities, but never rely on it as a main income source. Maintaining rationality in the bull-bear game is the long-term path to profitability.