Short Selling: How Smart Operators Generate Profits in Downward Markets

Key Questions Every Trader Must Ask Themselves

Is it possible to make money when prices fall? What is the difference between a traditional investment and a short selling strategy? Can traders really accumulate billions in profits with this tactic? These are the questions that drive many investors to explore an alternative beyond the conventional “buy low, sell high” model.

While most investors seek assets that appreciate over time, there is a segment of traders who have found profitability precisely in the opposite: price declines. This approach, known as short selling, represents one of the most controversial and potentially lucrative strategies in the financial market.

What Does Short Selling Really Involve?

Short selling is an investment operation that completely reverses the traditional trading process. Instead of buying an asset expecting its value to rise, the trader borrows that asset, sells it at the current price, and hopes to buy it back later at a lower cost.

The mechanism works as follows: the trader borrows shares, bonds, or another financial instrument from a broker without owning them initially. Then they sell these in the open market at the prevailing price. When the price drops as expected, they buy back the same units at a lower value and return the borrowed assets. The difference between the two prices constitutes their profit.

The mathematical equation is straightforward:

Profit or loss = (Initial sale price - Rebuy price) × Number of units

Let’s take a concrete example: a trader anticipating a decline plans to borrow 100 shares of a company valued at 50 euros each (total investment of 5,000 euros). After some time, if the price drops to 40 euros, the trader buys back those 100 units for 4,000 euros. Returning the borrowed shares, they realize a net profit of 1,000 euros.

However, if the prediction was incorrect and the price rises to 60 euros, the trader would have to spend 6,000 euros to close the position, resulting in a loss of 1,000 euros.

The Multiple Ways to Short Sell

There is no single way to implement this strategy. Modern markets offer various instruments that allow benefiting from price declines:

Direct Short Selling: The most traditional method involves borrowing shares from a broker and immediately selling them in the market, with the intention of buying them back later at a lower price. This is the most direct approach but requires access to certain authorized platforms.

Contracts for Difference (CFD): These instruments allow traders to speculate on price movements without owning the underlying asset. A CFD is an agreement between buyer and seller where the difference in value between opening and closing the position is exchanged. CFDs offer greater flexibility and accessibility for retail traders.

Put Options: These derivatives give the buyer the right (but not the obligation) to sell an asset at a predetermined price on a specific date. Buying puts is a short selling strategy because it profits when the asset’s price falls.

Futures: A futures contract obligates parties to exchange an asset at a fixed price on a future date. By selling futures contracts, traders bet that the price will decline before the contract’s expiration.

Inverse ETFs: These exchange-traded funds are designed to generate returns opposite to their reference index. If the index rises 10%, the inverse ETF falls 10%, allowing profits in bearish markets.

The Tesla Case: A Lesson of Two Opposite Years

No example better illustrates the potential and danger of short selling than what happened with Tesla between 2022 and 2023.

In 2022, after Elon Musk announced his intention to acquire Twitter in April, Tesla’s shares plummeted dramatically. This event became a feast for short sellers. Traders who bet on the decline were generously rewarded: those who shorted Tesla at $385 per share and bought back at $209 made $176 per share. In total, short-sellers accumulated nearly $14 billion in profits.

However, 2023 was radically different. Traders who, based on the previous trend, shorted at $100 expecting a similar drop faced an entirely opposite scenario. The stock price soared to $171, resulting in a loss of $71 per contract. Over the year, Tesla’s short sellers accumulated losses exceeding $6.5 billion.

This revealing contrast demonstrates that, although short selling can generate extraordinary gains, it also carries equally extraordinary risks.

Fundamental and Technical Analysis: Decision-Making Tools

Before executing any short position, traders use sophisticated analytical tools to identify overvalued assets or downward trending markets.

Fundamental Analysis: This approach examines a company’s financial health by comparing its performance with competitors and analyzing indicators such as P/E ratios, P/B ratios, and ROE. Financial reports, analyst estimates, and macroeconomic news can reveal if a stock is overvalued and vulnerable to price corrections.

Technical Analysis: By studying historical price and volume patterns, traders project future movements using tools like moving averages, the Relative Strength Index (RSI), Bollinger Bands, and candlestick formations. These indicators can signal overbought or oversold conditions.

Sentiment Indicators: The Volatility Index (VIX), short interest positions, and investor surveys provide clues about market emotional states and when an asset might be overvalued.

Each trader develops their own combination of tools based on their risk profile and time horizon.

Risk Management: The Critical Factor Often Overlooked

The risk in short selling is theoretically unlimited. Unlike buying a stock (where the maximum loss is the invested capital), when shorting, the price can rise indefinitely, generating unlimited losses. For this reason, risk management is not optional but imperative.

Stop-Loss Orders: These automatic orders close the position if the price reaches a predetermined level, limiting potential losses. A trader shorting can set an order to automatically buy back if the price rises by 20%, for example.

Diversification: Instead of concentrating all exposure in a single asset, traders spread their short positions across different sectors and assets, reducing the impact of incorrect predictions.

Hedging (Hedging): Instruments like call options allow traders to protect against adverse market movements. Someone who shorted a stock can buy a call option to limit potential losses.

Constant Monitoring: Since market conditions change rapidly, it is essential to continuously monitor positions and be prepared to adjust or close them.

Position Size Limitation: Restricting exposure to a specific percentage of the total portfolio ensures that an incorrect prediction does not become catastrophic.

Advantages of This Trading Tactic

Despite its risks, short selling offers genuine advantages. It provides a diversification mechanism, allowing profits in bearish markets when most investors face losses. Additionally, it has historically helped correct excessively inflated prices, preventing speculative bubbles and improving overall market efficiency.

For sophisticated traders with a good understanding of the market, it represents an additional strategic tool in their trading arsenal.

Disadvantages That Cannot Be Ignored

The main obstacle is the risk of theoretically unlimited loss. There is no ceiling to how high a price can go, while there is a floor: zero. This creates asymmetry in the risk-reward profile.

Additionally, research has shown that assets sold short tend to generate significantly lower returns in the long term due to the high risk involved. Transaction costs and commissions erode profits, especially if the price does not decline quickly.

The leverage (available on many trading platforms) can amplify both gains and losses exponentially. A miscalculation can turn a low-risk operation into a financial debacle.

Regulations also limit flexibility: many jurisdictions require official notification of significant short positions, prohibit “naked” short selling (without securing the prior loan of the asset), and impose temporary restrictions during periods of extreme volatility.

Final Considerations

Short selling is a double-edged strategy. It can generate extraordinary gains in bearish markets, as demonstrated by Tesla’s phenomenon in 2022. At the same time, it can produce catastrophic losses when predictions fail, as painfully illustrated by Tesla itself in 2023.

Success in this tactic depends on three critical factors: rigorous analysis (fundamental and technical), impeccable risk management, and prior experience in financial markets. It is not a recommended strategy for novice investors or those with low risk tolerance.

For those traders with the experience, discipline, and risk appetite required, short selling can be a legitimate component of a diversified portfolio. But always with a clear understanding that financial markets do not guarantee predictable outcomes, and today’s gain can become tomorrow’s loss at the speed of a social media announcement.