Bull and bear dance: An in-depth analysis of how short selling actually makes money

“The yin and yang principle” is perfectly applicable to the financial markets. When some people are bullish and making profits, there are inevitably others who are bearish and also able to profit—this is the logic of short selling. However, many people still have a vague understanding of the concept of shorting. This article will explain the principles, methods, advantages, and disadvantages of short selling from basic to advanced levels.

What exactly does short selling mean? A simple explanation

Let’s start with a straightforward definition: short selling (also called shorting) is when you predict that the price of an asset will decline. You borrow this asset from a broker, sell it immediately, and then buy it back at a lower price to return to the broker, pocketing the price difference.

In one sentence: Sell high first, buy low later.

This logic is completely opposite to going long (buying to profit from rising prices). Going long is optimistic about the future, so you buy first and sell later; short selling is bearish, so you sell first and buy later. It sounds counterintuitive, but that’s how the market operates.

It’s important to note that short selling can involve a wide range of assets—stocks, forex, bonds, and other traditional financial instruments—as well as derivatives like futures, options, and contracts for difference (CFDs). Moreover, you don’t need to own the asset outright; borrowing a share or contract to operate is called “securities lending” in finance.

Why does the market need a short selling mechanism?

Imagine a world without short selling: everyone can only buy to make money. What would happen? The market would become severely unbalanced—prices would skyrocket to absurd levels during rallies, and once sentiment reverses, prices would plummet straight down. (Historical market trends often reflect this pattern.)

If the market has sufficient long and short battles, each price movement becomes more stable, leading to healthier market operation. The existence of short selling provides a balancing force:

◆ Hedging tools — Holding heavy positions and worried about volatility? Short selling can hedge risks, similar to buying insurance.

◆ Burst bubbles — When a stock is severely overvalued, short sellers intervene to suppress the price, helping to de-leverage the market.

◆ Increase liquidity — Both longs and shorts can profit, encouraging active participation and naturally boosting trading volume.

What are the different ways to short?

Method 1: Securities Lending for Short Selling (Margin Trading)

This is the most traditional method. You borrow stocks from a broker and sell them. The barrier is relatively high—for example, in the US, brokers typically require a minimum account net worth of $2,000 and a total account value maintaining at least 30% in cash. Borrowed securities accrue interest, usually between 7%-10%.

This method isn’t very friendly for small funds unless you find brokers with lower thresholds.

Method 2: CFD Short Selling

This is currently the most flexible shorting tool.

Contracts for Difference (CFDs) are derivatives that track the price movements of underlying assets (stocks, forex, indices, commodities, etc.). You don’t own the actual asset; you bet on the price movement with the broker.

Compared to traditional stock shorting, CFDs have several advantages:

• Lower initial capital: Leverage (usually 5-20x), with 5%-10% margin, allows trading 10-20 times the capital.
• No commission: No trading commissions, lower costs.
• Low entry barrier: Some platforms require only $50 to open an account.
• Wide variety: One account can trade stocks, forex, indices, commodities, and cryptocurrencies.
• Simple operation: Just “sell and buy,” no need for securities lending.

The downside is that you pay overnight holding fees proportionally, and leverage is a double-edged sword—it amplifies gains and losses.

Method 3: Futures Short Selling

Futures are standardized contracts to buy or sell an asset at a set price at a future date. Shorting futures works similarly to CFDs but has disadvantages:

• Less flexibility: Must adhere to contract delivery dates; less flexible than CFDs.
• Higher margin requirements: Need more collateral, and trading rules are more complex.
• Higher risk: May involve physical delivery at expiry, with high risk of forced liquidation.

Conclusion: Individual investors are generally not suitable for shorting futures; this is mainly for institutions and professional traders.

Method 4: Buying Inverse ETFs

If the above methods seem too complicated, you can directly buy inverse ETFs. These funds track the inverse of stock indices, such as the ProShares UltraShort Dow30 (DXD) for shorting the Dow Jones, or ProShares UltraShort QQQ (QID) for shorting the Nasdaq.

Advantages include professional management and more controlled risk. Disadvantages are costs associated with rolling over positions and higher long-term holding costs.

Practical example: How to short a stock?

Take Tesla as an example. Suppose you observe that after reaching a historical high of $1243 in November 2021, the stock begins to decline. Technical analysis suggests it’s unlikely to break previous highs again. You decide to short on January 4, 2022.

Steps:

Step 1 (Jan 4): Borrow 1 share of Tesla from your broker and sell it at $1200, credited $1200 in your account.

Step 2 (Jan 11): The stock drops to $980. You buy 1 share back and return it to the broker, costing $980.

Profit: $1200 - $980 = $220 (excluding interest and transaction costs).

This illustrates the entire process of making money from short selling.

How to short forex?

The forex market is inherently two-way, allowing both long and short positions. Shorting forex is very common.

The principle remains “sell high, buy low,” but the asset is a currency pair. For example, if you expect GBP to depreciate against USD, you can sell GBP/USD and buy back later at a lower rate.

Example: A trader uses $590 margin (200x leverage) to sell 1 lot of GBP/USD at 1.18039. When the rate drops 21 pips to 1.17796, the profit is $219, yielding a 37% return.

However, forex is influenced by many factors—interest rates, trade balances, reserves, inflation, macro policies—so shorting forex requires strong fundamental analysis and risk awareness.

CFD shorting vs. traditional stock shorting, which is better?

Comparison (using Google stock as an example):

Clearly: CFD shorting achieves 10 times the return with less capital.

Core advantages of CFD shorting:

➢ High capital efficiency — control large positions with less capital, no need to tie up much funds

➢ Hedging risk — holding a long position in Tesla but worried about a crash? Short CFDs simultaneously to hedge

➢ Lower threshold — some platforms allow opening accounts with just $50, no minimum asset requirement

➢ Simple operation — traditional stock shorting involves “borrow-lend, sell, buy back, return,” four steps; CFDs only need two steps

➢ Tax advantages — stock profits are subject to capital gains tax; CFDs are not taxed in the same way

Risks of short selling you must know

While shorting looks attractive, risks cannot be ignored:

Risk 1: Forced liquidation

The securities you borrow still belong to the broker, who can demand you sell or buy back at any time, leading to forced liquidation. This can happen at the worst moment, causing actual losses.

Risk 2: Misjudgment leading to unlimited losses

This is the biggest pitfall: The maximum profit from going long is limited to the stock’s rise to zero, but the maximum loss from shorting is unlimited.

Example: Shorting a stock at $10 per share, the maximum profit is $9 per share (if it drops to $0). But if the stock rises instead, say to $100, you lose $90 per share. If it continues to rise to $1000, losses grow even more. When margin is insufficient, forced liquidation occurs, locking in losses.

This explains why short selling carries such high risk—profits are capped, but losses are unlimited.

Proper approach to shorting

◆ Not suitable for long-term holding

Shorting has limited profit potential (stocks can only fall to zero), but unlimited risk. Therefore, short positions should be quick and not held long-term. Holding long-term exposes you to forced liquidation risks and the broker may recall the borrowed securities at any time.

◆ Keep position sizes small

Short selling is best used for hedging large long positions, not as a primary investment strategy. Position sizes should be within reasonable limits; don’t go all-in on shorts.

◆ Avoid blindly increasing positions

Many traders increase their short positions when the market doesn’t move as expected—this is a big mistake. Markets can reverse unexpectedly. Cutting losses promptly is more important than stubbornly holding on. Whether making profits or losses, you should close positions or monitor carefully; don’t keep adding to losses.

Summary

Short selling is a double-edged sword. It can help hedge risks and increase returns, but can also cause huge losses if misjudged.

Key points:

1. Fully understand the mechanism and risks of shorting
2. Choose suitable tools (CFD is generally more user-friendly than futures)
3. Use reasonable leverage and position sizes based on market conditions
4. Stop profit and loss timely; avoid greed

Short selling is not a secret weapon but a tool in the market toolbox. Smart investors will flexibly use both long and short strategies to achieve dual-direction profits. But the prerequisite is a thorough understanding of risks and acting within your capacity.