How to short stocks and forex? Risks and opportunities are all here

“The Dao is called the unity of yin and yang.” The market has ups and downs; some see bullish opportunities while others see bearish risks. Most investors are accustomed to making money in a bull market, but smart traders understand that profits can also be made in a bear market — this is the value of short selling.

What is short selling? Why does the market need short selling?

Short selling is the opposite of bottom-fishing. Simply put, it means investors expect an asset to decline in value, so they sell it at a high price first (borrowing the asset to sell), then buy it back after the price drops (closing the position and returning the borrowed asset), earning the difference.

Imagine what would happen if the market only allowed buying long and not shorting? The prices would soar in a straight line during rallies and plummet during declines, making the market extremely unstable. With the short selling mechanism, both bulls and bears can balance each other, leading to more moderate market fluctuations.

Three major benefits of short selling:

1. Hedging risks. When the stock market is volatile and uncertain, and you hold a large position in a particular stock, you can short it to hedge against potential declines.

2. Preventing bubbles. When a stock is severely overvalued, short sellers can push down the price by selling, bringing the valuation back to a reasonable level.

3. Increasing liquidity. Combining long and short positions encourages participation in both rising and falling markets, naturally increasing market liquidity.

Common methods of shorting stocks

Margin Short Selling — The most direct but with high barriers

This is the traditional way of shorting. You borrow stocks from a broker and sell them at the current price, then buy them back after the price drops to return to the broker. The key is that borrowing stocks requires meeting certain conditions — your account must have sufficient cash, usually several thousand dollars or more in assets. Brokers also charge interest, making it costly.

CFD (Contract for Difference) — Low barrier but high risk

CFDs are financial derivatives that track the price movements of underlying assets (stocks, indices, forex, etc.). Unlike directly holding stocks, shorting CFDs only requires paying a margin to control a larger position — typically 5%-10% margin allows controlling 10 to 20 times the position size.

Comparison: Shorting 5 shares of a stock directly might cost thousands of dollars, but with CFDs, only a few hundred dollars are needed, thanks to leverage. However, leverage amplifies both profits and losses.

Futures — Flexible but requiring professional knowledge

Futures are standardized contracts that can be used to short any underlying asset. The principle is similar to CFDs, profiting from price differences. But futures are less capital-efficient than CFDs, and contracts have expiration dates, making them less flexible and possibly involving physical delivery. Unless you have professional expertise, it’s not recommended to short futures.

Inverse ETFs — Lazy shorting solution

If you don’t want to time the market yourself, you can buy inverse ETFs, such as QID (short Nasdaq) or DXD (short Dow Jones). These funds are managed by professional teams and have relatively controlled risks. The downside is higher costs due to continuous rebalancing to replicate short exposure.

Shorting forex — The realm of two-way trading

The forex market is inherently two-way. You can be bullish on the euro appreciating and go long EUR/USD, or be bearish on the pound and short GBP/USD.

Forex rates are influenced by multiple factors:

• Interest rates: Higher interest rates often attract capital inflows, strengthening the currency.
• Trade balance: Countries with strong exports tend to have stronger currencies.
• Foreign exchange reserves: Countries with ample reserves tend to have more stable currencies.
• Inflation levels: High inflation usually leads to currency depreciation.
• Economic data: GDP, unemployment rates, and other fundamentals impact exchange rates.
• Policy expectations: Market anticipations of central bank policies are reflected in rates.

Therefore, forex shorting is not just guessing whether prices will go up or down; it requires understanding how these factors interact.

The deadly risks of short selling — what you must know

Forced liquidation

Since the assets you short are borrowed, the lender (usually the broker) has the right to require you to close the position at any time. If forced to liquidate, you might be compelled to sell at the worst possible price, resulting in significant losses.

Unlimited loss trap

This is the most dangerous aspect of short selling. While long positions can only lose your initial capital (if the stock drops to zero), short positions have theoretically unlimited losses. For example, shorting a stock at $10 and the price surges to $100 results in a $9,000 loss. If your margin cannot cover this loss, your position will be forcibly closed.

An extreme example: a stock heavily shorted suddenly gets acquired, doubling in price overnight. All short sellers suffer huge losses, and many will be forced to close their positions.

Cost of misjudgment

Profiting from short selling depends on the market actually declining. If your judgment is wrong and prices rise instead, losses can accumulate rapidly. Especially with leverage, a single mistake can wipe out your entire account.

Short selling operational tips

1. Avoid long-term holding. Short selling is not suitable for long-term positions. The profit potential is limited (up to 100%), but losses are unlimited. Plus, you have to pay interest and face forced liquidation risks. Short positions should be quick in and out.

2. Keep positions moderate. Short selling is best used as a hedging strategy rather than a primary investment approach. If you are heavily long a stock, use a small short position to hedge risks. Never treat short selling as your main way to make money.

3. Do not add to positions. Many traders increase their short positions if the market moves against them, which is a big mistake. Sometimes the market will surprise you; in such cases, it’s better to cut losses rather than doubling down.

4. Strictly set stop-loss and take-profit levels. Close your position promptly when reaching your profit target or loss limit. Do not hold on out of hope or luck.

Summary

Short selling is not inherently a bad tool, nor is it only for experts. The key is understanding what you are doing. After grasping the principles, methods, and risks, and under controlled risk conditions, choosing suitable tools and implementing proper position management, short selling can become a useful part of your investment toolbox.

Never blindly follow others’ short-selling profits. Profitable shorting requires: confidence in the market trend, a reasonable risk-reward ratio, and proper position management. All are indispensable.