Betting on the decline: Everything you need to know about short positions in your investments

Introduction: When Prices Drop, Profits Rise

Most investors seek to buy assets cheaply to sell them at a higher price. But there is a less common group of traders who have learned to flip this logic: they make money precisely when prices fall. These are short sellers, an investment tactic that, although risky, can generate significant gains if executed correctly.

How does it work? Short operators borrow an asset they believe will decrease in value, sell it immediately, and then buy it back at a lower cost. The difference between the two prices is their profit. Although it sounds counterintuitive, in bear markets or during price bubbles, short selling can be one of the few profitable strategies available.

What Does It Really Mean to Bet on the Downside?

When you talk about short selling, what happens is this: you locate an asset (stocks, bonds, cryptocurrencies, commodities) that you expect to decrease in value. Then, you borrow that asset from a broker, sell it on the open market, and wait for its price to fall. Once it drops, you buy it back at a lower price and return what you borrowed, pocketing the difference.

The basic formula is simple: Profit = (Initial sale price - Buy-back price) × Quantity of units

Practical example of a short position

Imagine you identify that the stock price of Company X is overvalued. Today, it trades at 50 euros. You borrow 100 shares and sell them for 5,000 euros. Two months later, the price drops to 40 euros. You buy back the 100 shares for 4,000 euros, return them, and pocket 1,000 euros in profit.

But if the price had risen to 60 euros instead of falling, you would have had to buy at 6,000 euros to return the borrowed shares, resulting in a loss of 1,000 euros. This scenario illustrates why the risk in short positions is potentially unlimited.

Different Ways to Short Sell

There is no single way to execute this strategy. Depending on the asset and your risk profile, you have several options:

Traditional Short Selling: Borrow shares directly from a broker and sell them on the market. This is the most direct method but requires access to a securities lending facility.

CFD Contracts: A contract between you and a provider where the difference in the asset’s price between opening and closing is exchanged. They allow shorting without owning the underlying asset, though they carry risks due to inherent leverage.

Put Options: Buying a put option gives you the (not the obligation) to sell an asset at a fixed price. You profit if the price falls. More flexible than direct selling but requires understanding volatility dynamics.

Futures: Contracts that obligate you to buy or sell at a set price on a future date. Selling futures contracts is a bet that the price will decline.

Inverse ETFs: Funds that generate returns opposite to their benchmark index. If the index falls, you profit. A less leveraged way to benefit from declines.

How to Identify When to Bet on the Downside

Before opening any short position, you need to carefully analyze the market. Experienced investors use three main approaches:

Fundamental Analysis: Examines the financial health of the company, ratios like P/E (price/earnings), P/B (price/book value), ROE (return on equity), sector news, and macroeconomic context. If a stock is overvalued compared to its fundamentals and competitors, it’s a candidate for a short position.

Technical Analysis: Studies historical price patterns, trading volumes, moving averages, RSI (Relative Strength Index), Bollinger Bands, and candlestick formations. These indicators help identify inflection points and bearish trends.

Market Sentiment: Observes indicators like the VIX (volatility index), the level of open short positions, investor surveys. When sentiment is excessively bullish and panic is low, it may signal overbought conditions.

Each investor has their own set of favorite tools depending on experience, risk tolerance, and time horizon.

Tesla Case: Winners and Losers in 2022-2023

No example better illustrates the extremes of short selling than what happened with Tesla.

2022: The Short-Sellers’ Golden Year: When Elon Musk announced his intention to acquire Twitter in April, Tesla shares collapsed. Investors who shorted at $385 per share and bought back at $209 made $176 per contract. Overall, shorts extracted nearly $14 billion from Tesla’s market during that year.

2023: The Unexpected Punishment: The same traders, confident that the trend would continue, reopened short positions at $100. But the market turned. Tesla surged to $171. Result: accumulated losses exceeding $6.5 billion on short positions. Some traders lost $71 per contract.

This story underscores an uncomfortable truth: while profits can be enormous, so can losses. And they happen quickly.

Essential Tools to Protect Your Capital

Trading short without risk management is financial suicide. Here are the main techniques:

Stop-Loss Orders: Predefine a price level at which you will automatically close your position if the asset rises too much. If you short at 100 euros, you might set a stop-loss at 110 euros to limit losses.

Position Diversification: Don’t concentrate all your resources in a single short position. Spread risk across different assets and sectors.

Hedging with Options: If you have shorted a stock, you can buy a call option on the same stock to protect against extreme upward moves.

Constant Monitoring: Markets change rapidly. Short positions require active oversight and frequent adjustments.

Limit Position Size: Define the maximum percentage of your portfolio you will risk on short positions. Many professionals do not exceed 5-10%.

Advantages of Short Positions

• Diversification: You profit in bear markets when most lose.
• Price Correction: Help prevent extreme bubbles and improve market efficiency.
• Counter-cyclical Strategy: Can offset losses in long positions during corrections.

Critical Risks of Short Selling

• Unlimited Losses: There’s no cap on how high a price can go, but your capital is limited.
• Borrowing Costs: You pay interest on the borrowed asset, reducing profits if the decline is slow.
• Price Overreaction: Markets can move against you more than expected, especially during volatility.
• Regulatory Restrictions: Many jurisdictions limit or ban naked short selling and may impose restrictions during crises.
• Illiquidity: In stressed times, certain assets become difficult to buy back.

Is Short Trading Right for You?

Short positions are suitable for advanced investors with high risk tolerance and deep market understanding. It’s not a beginner’s strategy.

If you decide to try it, remember: transaction costs, commissions, and leverage effects can turn a small mistake into a catastrophe. Rigorous risk management is not optional; it’s mandatory.