Key Takeaways
Short selling (or shorting) refers to the act of selling an asset with the goal of buying it back later at a lower price.
Typically, shorting is done with borrowed funds, meaning it requires an initial margin (collateral), maintenance margin, and interest payments.
Short selling is widely used by traders and investors who wish to speculate on the markets or as a hedging strategy to offset potential losses in other assets.
Shorting downsides include the potential for unlimited losses if prices keep rising, liquidations, risk of short squeezes, and additional costs like borrowing fees.
Introduction
There are countless ways to generate profits in the financial markets. Some traders focus on technical analysis while others will invest in companies and projects based on fundamental analysis.
Typically, traders try to buy assets at a lower price to sell them later at a profit when the price goes up. But what if they are faced with a prolonged bear market, where prices are continually declining?
Shorting the market allows traders to profit from price declines. Entering a short position can also be an excellent way to manage risk and hedge existing holdings against price risk.
Short selling dates back to the 17th-century Dutch stock market, but became more prominent during events like the 2008 financial crisis and the 2021 GameStop short squeeze, where retail investors drove up prices to squeeze short sellers.
What Is Short Selling?
Short selling (or shorting) means selling an asset in the hopes of rebuying it later at a lower price. A trader who enters a short position expects the asset’s price to decrease, meaning that they are “bearish” on that asset.
So instead of just holding and waiting, some traders adopt the short-selling strategy as a way to profit from an asset’s price decline. This is why short selling can also be a good way to preserve capital during a market downtrend.
Shorting is very common in essentially any financial market, including the stock market, commodities, Forex, and cryptocurrency. Short selling strategies are widely used by retail investors and professional trading firms, such as hedge funds.
The opposite of a short position is a long position, where a trader buys an asset in the hopes of selling it later at a higher price.
Short selling is used for two primary purposes:
Speculation: Betting on a price drop to generate profit.
Hedging: Offsetting potential losses in other investments, such as a long position in a similar or related asset.
While stocks are the most common securities for short selling, the strategy can also apply to other assets like cryptocurrencies, bonds, or commodities.
How Short Selling Works
Let’s say you’re bearish on a financial asset. You put up the required collateral, borrow a specific amount of that asset, and immediately sell it. Now, you’ve got an open short position. If the market fulfills your expectations and goes lower, you buy back the same amount that you’ve borrowed and pay it back to the lender (with interest). Your profit comes from the difference between where you initially sold and where you bought.
Examples
Bitcoin short selling
You borrow 1 BTC and sell it at $100,000. Now you’ve got a 1 BTC short position for which you’re paying interest. The market price of Bitcoin goes down to $95,000. You buy 1 BTC and return that 1 BTC to the lender (usually, the exchange). Your profit, in this case, would be $5,000 (minus the interest payments and fees). However, if the price rises to $105,000, repurchasing 1 BTC will lead to a loss of $5,000 plus fees and interest.
Stock short selling
Suppose an investor believes that XYZ Corp’s stock, currently trading at $50 per share, will decline. They borrow 100 shares and sell them for $5,000. If the price drops to $40, they repurchase the shares for $4,000, return them, and profit $1,000 (minus fees). However, if the price rises to $60, repurchasing will cost $6,000, resulting in a $1,000 loss, plus additional costs like borrowing fees or interest.
Types of Short Selling
There are two main types of short selling:
Covered short selling: Involves borrowing and selling actual shares, which is the standard practice.
Naked short selling: Selling shares without first borrowing them, which is riskier and often restricted or illegal due to potential market manipulation.
Requirements for Short Selling
Since short selling involves borrowing funds, traders are usually required to provide collateral through a margin or futures account. If you are shorting via a margin trading broker or exchange, it’s important to consider the following:
Initial Margin: In traditional markets, the initial margin is typically 50% of the shorted stock’s value. In crypto markets, the requirements depend on the platform and the leverage used. For example, with 5x leverage, a $1,000 position would require $200 in collateral.
Maintenance Margin: The Maintenance Margin ensures that the account has sufficient funds to cover potential losses. It’s often calculated based on the trader’s Margin Level (Total Assets / Total Liabilities).
Liquidation risk: If the Margin Level drops too low, the broker or exchange may issue a margin call, requesting users to deposit more funds or simply liquidate positions to cover borrowed funds, potentially resulting in significant losses.
Benefits of Short Selling
Short selling can offer many advantages to investors and traders:
Profit in declining markets: Enables traders to capitalize on falling prices, unlike traditional long-only strategies.
Hedging: Can protect portfolios by offsetting losses in long positions, especially in volatile markets.
Price discovery: Some argue that short sellers help correct overvalued stocks by reflecting negative information, improving market efficiency.
Liquidity: Increases trading activity, making it easier for buyers and sellers to transact.
The Risks of Shorting
There are a number of risks to consider when it comes to entering a short position. One of them is that, in theory, the potential loss on a short position is infinite.
Countless professional traders have gone bankrupt over the years while being short a stock. If the stock price increases thanks to some unexpected news, the spike up can quickly “trap” short sellers (known as a short squeeze).
Other potential downsides of short selling include:
Borrowing costs: Fees and interest vary, especially for hard-to-borrow stocks with high demand.
Dividend payments: In stock markets, short sellers must pay any dividends issued during the short period, adding to costs.
Regulatory risks: Temporary bans or restrictions during market crises can force short sellers to cover at unfavorable prices.
Market and Ethical Considerations
Short selling is controversial. Critics argue it can exacerbate market declines or unfairly target companies, potentially harming employees or stakeholders. For example, aggressive short selling during the 2008 financial crisis led to temporary bans in several countries. However, proponents counter that short selling enhances market transparency by revealing overvalued or fraudulent companies.
Regulators balance these concerns with rules like the uptick rule (restricting short sales during rapid declines) and disclosure requirements for large short positions. In the US, the SEC’s Regulation SHO (Regulation of Short Sales) governs short selling to prevent manipulation, such as naked shorting.
Closing Thoughts
In summary, short selling is a popular strategy that allows traders to profit from declining prices. Whether used for speculation or hedging, short selling remains a core part of traditional and crypto markets. However, it’s important to consider the risks and downsides of short selling, including unlimited losses, short squeezes, and transaction costs.
Further Reading
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