Short selling in the stock market: the strategy to win in bearish markets

Why do traders decide to short?

In financial markets, there are two fundamental ways to generate profits: buying in anticipation of the price rising (long position) or selling in anticipation of it falling (short selling). While most beginner traders focus on the first option, experienced traders know that mastering short positions is key to thriving in downtrends.

Shorting allows you to capitalize precisely when prices fall, something that happens frequently in volatile markets. Moreover, it is not just a speculative tactic: short selling in the stock market also serves as a hedging tool to protect existing portfolios against price risks. This versatility has made shorting essential in stock markets, cryptocurrencies, forex, and commodities.

The mechanism: how it really works

Short selling is based on a simple but powerful concept: you borrow an asset, sell it immediately at the current price, and then buy it back at a lower price to return what was borrowed, pocketing the difference.

Practical example with Bitcoin

Imagine you are shorting Bitcoin. You borrow 1 BTC when it is priced at 100,000 USD and sell it immediately. Now you have an open short position where you pay interest daily.

If your analysis is correct and Bitcoin drops to 95,000 USD, you buy back 1 BTC at the new price and return it to the lender. Your profit would be 5,000 USD minus borrowing costs and commissions. But if Bitcoin rises to 105,000 USD, your loss would be 5,000 USD plus additional expenses.

The case of a traditional action

An operator believes that the shares of XYZ Corp ( currently at 50 USD) will fall. He borrows 100 shares and sells them for 5,000 USD. When the price drops to 40 USD, he buys them back for 4,000 USD, returns the loan, and makes a profit of 1,000 USD ( after deducting commissions). On the other hand, if the price rises to 60 USD, the buyback would cost 6,000 USD, resulting in a loss.

The technical requirements you cannot ignore

To short sell, you need access to a margin or futures account with your broker or exchange. This involves several critical elements:

Initial margin: it is the collateral you deposit. In traditional markets, it is usually 50% of the short value. In cryptocurrencies, it depends on the leverage; with 5x, a position of 1,000 USD requires only 200 USD of collateral.

Maintenance margin: ensures that you have enough funds to cover losses. It is calculated by dividing your total assets by your total liabilities.

The liquidation risk: if your margin level falls too low, the exchange will issue a margin call. You will need to deposit more funds or close positions, which can result in significant losses.

Two ways to short

Covered shorting: you borrow the asset and actually sell it. It is the standard and legal practice in most jurisdictions.

Naked shorting: you sell without having borrowed first. It is riskier and often prohibited because it opens the door to market manipulation.

Real Advantages of Shorting

• Gains in Declines: while others lose money, you gain profits.
• Wallet Protection: you compensate for losses in long positions
• Market Efficiency: shorting helps identify overvalued companies or those involved in fraud, improving transparency.

The risks you should be aware of

( Theoretically unlimited losses

This is the fundamental difference with long positions. If you buy a stock at 50 USD, your maximum loss is 50 USD ) if it goes to zero ###. But in short selling, there is no upper limit: if the stock rises to 100, 500, or 1,000 USD, your loss grows without a ceiling.

( Short squeeze

It is when the price rises rapidly, “trapping” short sellers. Many are forced to close positions simultaneously, further accelerating the rise. This notably happened with GameStop in 2021.

) Cumulative Costs

Loan commissions vary according to the demand for the asset. In stocks, you also have to pay dividends issued during your short period, increasing expenses.

Regulatory restrictions

During market crises, regulators may prohibit or temporarily restrict shorting, forcing you to close positions at unfavorable prices.

The regulatory debate

Short selling remains controversial. Critics argue that it amplifies market downturns and harms legitimate companies. During the 2008 crisis, temporary bans in several countries reflected this concern.

Defenders counter that shorting reveals fraud and overvaluation. To balance this, regulators implement rules like the uptick rule, which limits short sales during rapid declines. In the U.S., the SEC Regulation SHO establishes requirements to prevent manipulation.

Final Reflection

Short selling in the stock market is a powerful tool for the modern trader. It works for both speculation and risk management. However, it requires rigorous discipline: understanding margin requirements, constantly monitoring your liquidation level, and respecting the risks of potentially unlimited losses.

The difference between a trader who thrives by shorting and one who goes bankrupt lies in risk management, not in the strategy itself.