What is short selling? The dual risks and opportunities of trading that investors must know

Understand the Risks First, Then Learn Short Selling

Many novice investors hear the term “short selling” and immediately get excited, as if they’ve discovered a new continent of profit. But in reality, the question of what short selling is should start with its risks.

There is a saying circulating in the market: “Long positions have limited losses, short positions have unlimited losses.” This is not an alarmist statement. When you buy a stock long, the worst outcome is the stock price drops to zero, and your loss equals your principal. But short selling is different — theoretically, a stock can rise infinitely, and so can your losses. For example: you short 100 shares at 10 yuan, costing 1,000 yuan. If the stock price rises to 100 yuan, you lose 9,000 yuan. And if it continues to rise? The loss becomes even more terrifying.

This is also why brokerages set up forced liquidation mechanisms: when your margin can no longer cover your losses, the trade will be forcibly closed, possibly locking in losses at the most unfavorable price.

What Does Short Selling Mean? Simply Put, “Sell First, Buy Later”

Given the high risks, why do some still short sell? Because the core of short selling is that it provides a mechanism to profit in a declining market.

The logic of short selling (also called “going short”) is simple:

• You judge that an asset will decline in the future
• Borrow this asset from the broker and sell it at the current price
• When the price drops, buy it back at a lower price
• Return the asset to the broker, pocketing the difference

This is exactly the opposite of “buy first, sell later” in long positions. But behind this seemingly simple logic lie complex risks and various operational methods.

Four Main Ways to Short Sell Compared

1. Margin Short Selling — Traditional Stock Trading Method

The most direct way to short stocks is through margin trading. After opening a margin account, you can borrow stocks from the broker to short sell.

Taking the well-known overseas broker TD Ameritrade as an example, the threshold for short selling is at least $2,000 in cash or equivalent securities in the account, with a maintained net asset ratio of 30%. The interest rate varies based on the short amount:

Advantages of this method are straightforwardness and regulation; disadvantages include high thresholds, higher costs, complex procedures, and it is more suitable for investors with large capital.

2. CFD — Flexible Derivative Instruments

For traders who want quick access with limited funds, Contracts for Difference (CFD) are a good choice. They are financial derivatives that closely track the price of the underlying asset (stocks, indices, commodities, forex, etc.).

Advantages of CFD short selling:

• Low minimum deposit (platforms start as low as $50)
• Flexible operation, can enter and exit anytime
• Supports multiple asset classes, unified trading in one account
• No physical delivery or complex rollover

Disadvantages include leverage, which amplifies risk.

3. Futures Short Selling — Complex but Efficient

Futures are contracts to buy or sell an underlying asset at a predetermined price at a future date. Agricultural products (cotton, soybeans), energy (oil, natural gas), financial assets (stocks, bonds) can all be futures.

The principle of futures shorting is similar to CFD, but with higher trading thresholds, larger margin requirements, and contracts with expiration dates, making it less flexible. Plus, it may involve physical delivery, rollover operations, and other complex steps. Individual investors are generally not advised to attempt futures shorting lightly. These tools are more suitable for professional institutions or trained individual investors.

4. Inverse ETFs — Lazy Short Selling Strategy

If the above three methods seem too complicated, consider buying inverse ETFs. These ETFs mainly short stock indices, managed by professional teams.

Common examples:

• Shorting the Dow Jones Index with DXD
• Shorting the Nasdaq Index with QID

Advantages include controlled risk, professional management, and simple operation. Disadvantages are that, due to using derivatives to replicate index trading, there are rollover costs, making the investment more expensive.

Practical Case of Short Selling: Tesla

No matter how thorough the theory, real examples are more intuitive. Let’s look at how to short Tesla specifically.

Tesla’s stock price hit a record high of $1243 in November 2021. Afterwards, the price fluctuated, and technical analysis showed difficulty breaking through previous highs. Suppose an investor fails the judgment when Tesla’s price hits a second peak on January 4, 2022, and decides to short:

Operation process:

• January 4: Borrow 1 share of Tesla from the broker and sell at $1200, account credits $1200
• January 11: Stock drops to around $980, buy back 1 share and return to the broker, costing $980
• Profit: $1200 - $980 = $220 (excluding interest and transaction fees)

This is a successful short sale.

Short Selling Forex Currencies

The forex market is a two-way market; going long and short are equally common. Shorting a currency means the investor believes that one currency will depreciate relative to another.

Practical example: GBP/USD trade

On a trading platform, an investor uses $590 margin with 200x leverage to short 1 lot of GBP/USD at an opening rate of 1.18039. When the exchange rate drops 21 pips to 1.17796:

• Profit: $219
• Return rate: 37%

This demonstrates the high efficiency of leveraged short selling, but also highlights the high risk behind it. Exchange rates are influenced by multiple factors such as interest rates, exports/imports, foreign exchange reserves, inflation, and macro policies, making misjudgment likely.

Why Is Short Selling Beneficial to the Market?

The social value of short selling lies in providing market balance.

What happens if only long positions are possible (only profiting from rising prices)? The market would become extremely unstable — soaring during upswings and crashing during downturns. Without short sellers to restrain the market, bubbles will grow larger and larger.

The three main functions of short selling are:

◆ Hedging Risks When you hold a heavy stock position, market volatility increases, and outlooks are uncertain, shorting related assets to hedge risks is a wise move.

◆ Burst Bubbles Overvalued stocks attract short-selling institutions. Shorting can push prices down, making valuations more reasonable, and promoting corporate transparency and regulation.

◆ Improve Market Liquidity Combining long and short positions encourages participation regardless of market direction, leading to higher trading volume and better liquidity.

Three Major Risks of Short Selling

1. Forced Liquidation Risk

The ownership of the shorted securities still remains with the broker, who has the right to demand you close the position at any time. Once forced out, you may be forced to exit at the worst possible price, incurring losses.

2. Infinite Losses Due to Judgment Errors

The most critical risk of short selling: limited profit, unlimited loss. Stocks can rise infinitely, and your losses can also be unlimited. Under the margin system, this means the risk of liquidation is always present.

3. Long-term Holding Risks

Many investors think short selling can be held long-term like long positions. But in fact, it’s not the case. The profit space for shorting is inherently limited (stock prices can only fall to zero), and holding longer makes you more passive:

• Accumulating interest costs
• Broker may recall borrowed securities at any time
• Losses can expand if the stock moves upward
• The risk of forced liquidation always exists

Four Disciplines for Short Selling Investment

Since short selling involves risks, rules must be followed:

◆ Short-term Quick Entry and Exit Short selling is not suitable for long-term holding. When profits are realized, close the position immediately. Don’t hold out in hopes of more. If the judgment is wrong, cut losses quickly.

◆ Control Position Size Within Reasonable Limits Treat short selling as a hedging tool rather than a main investment strategy. Position size should be reasonable; avoid over-leverage.

◆ Avoid Blindly Adding to Positions Many losses come from stubbornness. When the market doesn’t meet expectations, keep adding to the position, resulting in deeper losses. Trust that the market always has unexpected turns.

◆ Set Clear Stop-Loss and Take-Profit Points Regardless of profit or loss, set clear exit points. Discipline in execution is more important than trying to predict the future.

Ultimate Insights on Short Selling

What is short selling? It is both a risk tool and a risk management tool. Many wealthy individuals have made big money through short selling, but only when they have a real edge in the market and make decisions based on reasonable risk-reward ratios.

Blindly shorting, heavy short positions, or long-term shorting are like opening the safety door of a gunpowder warehouse — an explosion is only a matter of time.

Mastering short selling begins with mastering risks. The ultimate purpose of short selling is not to make quick money, but to add a survival option in the complex market.