The core mechanism of reverse trading: the art of investing to profit from market downturns

“The unity of yin and yang is called the Dao.” The fundamental logic of the investment market is the balance between bullish and bearish forces. When some see gains, others see losses; when some profit from rising prices, others profit from falling prices. This seemingly opposing trading direction actually forms the basic framework of modern financial markets. So, how can we systematically understand and apply the profit mechanisms in a downtrend?

Reverse trading is not gambling, but an art of risk management

Reverse trading (commonly known as short selling) can be understood as follows: When predicting that the market will decline, investors borrow relevant securities from brokers, sell them at the current price, and buy them back after the price drops, earning the difference.

This process seems simple, but the logic behind it warrants deeper reflection:

First, the premise is predicting a decline. The logic of going long is “buy low, sell high,” whereas reverse trading is “sell high, buy low”—the thinking is completely opposite. Long investors believe prices will rise in the future, while reverse traders rely on falling prices to profit.

Second, the scope of trading objects is broad. Whether it’s stocks, forex currency pairs, bonds, or derivatives like futures and options, all can be used for reverse trading. The key is choosing the tools that best match your risk tolerance.

Third, no need to own the assets in advance. This is the core innovation of reverse trading. Investors do not need to hold securities; they only need to borrow securities via the broker’s margin lending service, then sell them. This process is called “short selling” in finance and is an important part of modern securities markets.

Why does the market need a reverse trading mechanism?

What happens if there is no reverse trading in the market? The answer is: The market would become extremely volatile and unstable.

Imagine a market where only long positions are allowed—no short selling. When sentiment is optimistic, capital floods in, and stock prices soar without reason; once sentiment reverses, a collective stampede occurs, causing prices to plummet. Such markets are full of bubbles and risks, detrimental to all participants.

When both long and short trades coexist, every price movement is the result of rational game theory. The forces of bullishness and bearishness constantly counterbalance each other, leading to prices that more accurately reflect value, and market operation becomes more stable and orderly.

Three main functions of reverse trading in the market:

1. Hedging investment risks — When investors hold an asset but worry about short-term declines, they can hedge risks through reverse trading. For example, holding a stock long while selling futures contracts on the same stock can offset potential losses during a price drop.

2. Breaking asset bubbles — When a stock or asset is severely overvalued, short-selling institutions step in to short, causing the price to fall. Although this may seem destructive, it actually corrects market pricing and promotes rationality. Many companies exposed to fraud or management issues after being heavily shorted are often revealed through this mechanism.

3. Increasing market activity — If profits could only be made from rising prices, investor participation would decline. Reverse trading allows investors to profit whether the market goes up or down, attracting more capital and increasing market liquidity.

Four ways to implement reverse trading

Short selling via margin: the most direct but with the highest threshold

This is the traditional method of short selling. Investors borrow stocks from brokers, sell them at the current price, and buy back later at a lower price to return to the broker. The process involves margin requirements, which vary among brokers.

For example, some international brokers require accounts to hold at least $2,000 in cash or equivalent securities, maintaining a net asset ratio of 30% of the total account value. Additionally, interest is paid monthly, with rates decreasing as the borrowed amount increases.

This method’s advantage is that it is the most formal and straightforward, but the drawbacks are high thresholds, higher costs, and complex procedures.

Contracts for Difference (CFDs): a new leverage tool option

CFDs are financial derivatives that allow investors to profit from price movements without owning the underlying assets. Similar to futures but more flexible.

Core advantages of CFDs over traditional stock trading include:

• Higher capital efficiency: Leverage allows investors to control positions 10-20 times the actual trading amount with only 5%-10% margin.
• Diverse trading categories: One account can trade stocks, forex, indices, gold, oil, and even cryptocurrencies without multiple accounts.
• No stamp duty: Profits are not subject to capital gains tax in many jurisdictions.
• Simplified operation: Only “sell-buy” steps are needed, without borrowing or returning securities.

However, CFDs also have disadvantages—overnight holding costs and the leverage effect amplifies both gains and losses.

Futures reverse trading: complex but efficient

Futures are standardized contracts based on commodities or financial assets. The principle of shorting via futures is similar to CFDs, both profit from price differences. But futures have higher entry thresholds and require more professional knowledge.

Futures require executing trades at a specified price at a specified time, making them less flexible than CFDs. When margin is insufficient, positions are forcibly liquidated, and contracts approaching expiry may involve physical delivery. These tools are more suitable for institutional or professional investors, and generally not recommended for retail investors.

Inverse index funds: a passive and simple solution

If you do not want to judge market trends yourself or are unfamiliar with complex tools, you can choose inverse ETF funds. These funds are designed to short stock indices, such as inverse Dow Jones or Nasdaq products.

Advantages include professional management, relatively controlled risks, and no need for self-operation. The downside is higher costs due to complex operations like rebalancing.

Practical examples: how to use reverse trading in stocks and forex

Stock reverse trading example:

Suppose a stock hits a historical high in November 2021 and then begins to retrace. Technical analysis shows it struggles to break previous highs during the rebound. An investor shorts when the second breakout fails in January 2022, with the process:

• Step 1: Borrow 1 share from the broker and sell immediately, gaining about $1,200 in the account.
• Step 2: One week later, when the stock drops to around $980, buy back 1 share and return it to the broker.
• Step 3: Ignoring interest and transaction costs, profit is approximately $220.

This example demonstrates the basic logic of reverse trading—sell high, buy low.

Forex reverse trading example:

The forex market is inherently bidirectional, allowing traders to bet on currency appreciation or depreciation. Suppose an investor predicts a currency pair will decline, selling 1 lot at an entry price of 1.18. When the exchange rate drops 21 pips to 1.17, with a margin of $590 (200x leverage), they earn a profit of $219, a 37% return.

Forex is complex because exchange rates are influenced by multiple factors: interest rates, balance of payments, foreign exchange reserves, inflation expectations, macro policies, monetary policies, and market sentiment. Engaging in forex reverse trading requires strong analytical skills.

Reverse trading vs traditional stock trading: tool comparison

Taking a tech stock as an example, comparing CFD shorting with traditional short selling:

The table shows that CFDs allow earning the same profit with less capital, with a return rate ten times higher. This demonstrates the power of leverage.

Why does reverse trading attract investors?

➢ Capital leverage effect — controlling 10-20 times the position with only 5%-10% of the actual trading amount, especially attractive to small funds.

➢ Flexible risk hedging — can hedge market risks while holding long positions, acting as an “insurance.”

➢ Low entry barriers — compared to traditional margin trading requiring thousands of dollars, some derivatives require only tens of dollars.

➢ Simplified trading process — only two steps: buy and sell, versus four steps in margin lending (borrow, sell, buy back, return).

➢ Tax advantages — in some regions, reverse trading products are exempt from capital gains tax, increasing net returns.

Hidden risks of reverse trading: must pay attention

Unlimited losses trap

This is the biggest risk in reverse trading. The maximum loss for a long position is the principal, since stock prices can only go down to zero; but the maximum loss for a short position is unlimited, as prices can theoretically rise infinitely.

For example: a trader goes long 100 shares at 10 yuan, spending 1,000 yuan. Worst case, the stock drops to zero, losing 1,000 yuan. But if shorting, the same 100 shares, if the price rises from 10 to 100 yuan, the loss is 9,000 yuan. If prices continue to rise, losses are unlimited.

Moreover, under margin rules, once losses exceed the margin, brokers will forcibly close the position, leaving no room for the investor to choose.

Judgment errors

Reverse trading relies on correctly predicting a decline. Markets are unpredictable, with frequent black swan events. Any misjudgment can lead to losses if prices move against expectations.

Borrowed securities being recalled

The securities involved are not owned by the investor; ownership always remains with the broker or lender. Brokers can demand the return at any time, forcing the investor to close positions, which may cause unnecessary losses.

Proper use of reverse trading

Given these risks, investors should follow some principles:

◆ Stick to short-term trading — Do not treat reverse trading as a long-term strategy. Profit potential is limited, and holding positions long increases the risk of forced liquidation and the chance of securities being recalled.

◆ Keep positions moderate — Reverse trading can be used for hedging but should not be the main investment approach. It is recommended that position size does not exceed a safe proportion of total assets.

◆ Avoid adding to short positions after misjudgment — Many investors try to “average down” on short positions after errors, which is very dangerous. Short selling requires flexibility; if a mistake is identified, close the position promptly.

◆ Cultivate risk awareness — The leverage characteristic of reverse trading makes it highly risky. Before using any reverse trading tools, fully understand the risks, set stop-loss levels, and adhere strictly to risk management.

Summary

Reverse trading is not about “shorting for the sake of shorting,” but about having opportunities to profit at different market stages and maintaining market stability. The essence of short selling is risk management, not speculation or gambling.

While some investors have achieved huge gains through reverse trading, such success is based on in-depth market research, strict risk control, and substantial practical experience. If you lack market confidence or have no respect for risks, reverse trading will only cause faster losses. The key is to make well-considered decisions with a reasonable risk-reward ratio, rather than blindly following the crowd.