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Core Mechanism of Short Selling: From Selling to Covering

Many novice investors entering the market always believe that stocks only make money when they rise, and lose money when they fall. But in reality, through the strategy of short selling stocks, investors can profit during downward price movements.

Short selling (also called shorting, going short, or放空) appears simple in principle but requires thorough understanding: an investor predicts that a certain stock will decline in the future, so they sell it first, then buy back (close position) after the price drops, earning the price difference. In this process, the short seller initially does not hold the stock, so they need to borrow (margin loan) the stock from a broker, sell it, and finally buy it back at a lower price to return to the broker.

For example, suppose a stock is shorted at 50 yuan at a high point, and three months later drops to 30 yuan; closing the position at this point yields a profit of 20 yuan. This is opposite to the logic of going long (buy first, then sell), but the profit principle is similar.

It is especially important to emphasize: The risks and rewards of short selling are asymmetric. The maximum profit is limited to the stock price dropping to zero, but the maximum loss is unlimited—if the stock price keeps rising and you do not cut losses in time, your losses can grow infinitely.

Four Key Conditions Determining the Feasibility of Short Selling

First: Understand the local market’s short selling rules

Different countries and regions have vastly different restrictions on short selling. Some areas prohibit short selling entirely, others allow it but with many restrictions. In markets where short selling is permitted, investors need to open corresponding accounts to operate.

Margin account route: Short selling via broker margin accounts requires meeting specific conditions—being at least 20 years old, having local tax residency, an account opened for over three months, and at least ten transactions in the past year. The risks of margin short selling include: limited stock sources (not all stocks can be borrowed), high borrowing costs, and risks entirely borne by the short seller.

Derivatives route: Using futures or contracts for difference (CFDs) for shorting is more flexible, as these instruments are inherently two-way (can go long or short), with adjustable leverage multiples, and no borrowing restrictions.

Second: Choose targets with genuine shorting value

Not all stocks are worth shorting. The key is to find those that are seriously overvalued compared to their intrinsic value. Judging criteria include:

• Deterioration of company finances: revenue decline, net profit turning negative, gross margin continuously decreasing—such companies are highly likely to be sold off by institutions
• Industry cycle judgment: an industry that has already experienced a significant rise and valuation peaks is more likely to decline
• Technical signals: stock price reaching important resistance levels but failing to break through, or in overbought conditions

Most importantly, enter at relatively high levels. Shorting at low levels risks large losses if the price rebounds. Conversely, shorting at high levels means “large profit potential with small risk.”

Third: Set up risk control mechanisms

Short selling operations must set stop-loss points. The maximum loss per trade should be within 1-3% of total capital, to protect principal over multiple trades.

Also, set reasonable stop-loss distances based on stock volatility. Hot stocks with large swings should have wider stop-loss points; small-cap stocks with low liquidity should have tighter stops.

Fourth: Precise capital allocation

Opportunities for short selling are often limited, but once a clear short signal appears, it’s advisable to increase investment appropriately. This does not mean investing all funds in a single trade, but rather focusing on high-probability opportunities under risk-controlled conditions.

Three Practical Tips for Short Selling

Prefer short-term trading: Short selling is best done with intraday or short-term strategies, lasting no more than a few weeks. The benefit is quick profit realization and avoiding black swan risks associated with long-term holdings. Holding short positions long-term involves many uncertainties, including company fundamentals improving or market sentiment shifting.

Strictly follow trading plans: Before entering, clearly define stop-loss and take-profit points. Do not change plans due to price fluctuations. Many short sellers become greedy when profits are in hand, resulting in losing all gains when prices rebound.

Avoid excessive leverage: Although some tools offer high leverage, beginners should not exceed 5x leverage. High leverage is tempting for quick gains but accelerates liquidation when the market moves against the position.

Warnings About Short Selling Traps

Many famous short-selling cases in history ended in failure. In 2021, some short sellers persisted in shorting leading new energy vehicle companies, only to be trapped for months or over a year. This shows that:

• Short selling cannot fight against long-term trends; going against the big trend often results in heavy losses
• Sudden reversals in company performance or policy support can catch short sellers off guard
• Shorted companies may buy back shares or take other countermeasures, pushing up the stock price

Therefore, before shorting, ensure you have thoroughly researched opposing viewpoints, understood all scenarios that could prove you wrong, and set stop-losses sufficient to handle these scenarios.

Summary

Short selling stocks can indeed generate profits in declining markets, but it is a high-risk trading strategy. To succeed, you need to: clearly understand local market rules, accurately identify overvalued targets, strictly implement risk controls, and quickly enter and exit rather than hold long-term positions.

If unsure, it is recommended to practice with demo accounts first, accumulate enough experience, and then invest real money. After all, preserving capital and steady growth are the ultimate goals of investing.