Shorting: How to trade in falling markets

Key Points

• Shorting means selling an asset with the expectation of buying it back at a lower price.
• This strategy requires borrowed funds, initial collateral, maintenance margin, and interest payments.
• Traders use shorting for both speculation and risk management.
• The disadvantages include infinite loss potentials, liquidations, short squeezes, and borrowing costs.

When did shorting arise, and why does it matter?

Shorting is not a new phenomenon. This trading strategy was first practiced in the 17th century on the Dutch stock market. However, it was only in recent years, particularly during the financial crisis of 2008 and the GameStop episode in 2021, that it became a common topic. During the financial crisis, the world saw how short sellers pushed the markets lower, and in 2021, retail investors turned the tables by driving prices up and trapping short sellers in what became known as short squeezes.

Basic Understanding of Shorting

Shorting is fundamentally about making money when things go down. Unlike traditional investing, where you buy low and hope to sell high, shorting flips the logic around. You first sell ( by borrowing the asset) and buy it back later when the price drops.

This approach allows traders and investors to profit during bear markets, where prices continuously fall. It can also be an effective way to protect your existing holdings from market risk.

Shorting is prevalent in almost all financial markets - from stocks to cryptocurrencies, commodities, and currencies. Both retail investors and professional trading firms like hedge funds actively use the strategy.

How shorting is practiced in practice

The process behind shorting is relatively straightforward: You decide to be bearish on a specific asset. You deposit the necessary collateral, borrow the asset in question from a broker or exchange, and sell it immediately on the market. Now you hold an open short position.

If the market moves as expected and the price falls, you buy back the same amount of asset, return it to the lender, and pocket the difference as your profit ( of course after paying interest and fees ).

Real examples of shorting

Bitcoin shorting: Let’s say you borrow 1 BTC and sell it for 100,000 USD. If the price of Bitcoin drops to 95,000 USD, you buy back 1 BTC for 95,000 USD and return it to the lender. Your result would be 5,000 USD in gross profit before interest and fees are deducted. But if the price spikes to 105,000 USD, your repurchase becomes more expensive, and you incur a loss of 5,000 USD plus costs.

Short selling stocks: Assume you believe that XYZ Corp stock, trading at $50, will fall. You borrow 100 shares and sell them for $5,000. If the price climbs to $40, you buy back for $4,000 and make a profit of $1,000 minus fees. Conversely, if the price jumps to $60, the buyback costs $6,000 and results in a loss of $1,000 plus borrowing costs.

The two variants of shorting

The market operates with two primary shorting models:

Covered shorting actually involves borrowing and selling the asset - it is the standard method and generally accepted.

Naked shorting means selling without first borrowing the asset. This variant is riskier and often prohibited or heavily regulated, as it can facilitate market manipulation.

What do you need to know about margin requirements?

Shorting requires capital as collateral. If you trade through a margin broker or cryptocurrency platform, you need to understand these key elements:

Initial margin: In traditional markets, 50% of the asset's value is typically required. In cryptocurrency markets, this varies by platform and leverage. With 5x leverage, a $1,000 position would require only $200 in collateral.

Maintenance Margin: This ensures that your account always has enough funds to cover potential losses. If your margin ratio falls too low, the broker issues a margin call. You must either deposit more or accept that positions will be closed (liquidated), which can lead to significant losses.

Applications and Benefits of Shorting

Shorting serves two primary purposes in the trader's toolbox:

Speculation: You bet on price declines to generate profit - it is the most aggressive use.

Hedging: You use shorting to offset potential losses in other investments. For example, if you have a long position in an asset, a short position in a correlated asset can protect your overall portfolio.

Traders appreciate shorting because it opens up the opportunity for profit during market declines - something that traditional “buy and hold” cannot. It also increases market liquidity, making it easier for everyone to trade.

Some argue further that short sellers perform an important service by exposing overvalued or fraudulent companies, thereby improving market transparency.

Risk factors you must not ignore

With every advantage comes significant risks. The most critical? The potential loss on a short position is theoretically unlimited. Numerous professional traders have gone bankrupt because they shorted without proper risk management.

If a stock or cryptocurrency suddenly rises due to positive news or speculative buying, prices can quickly “trap” short sellers. This phenomenon - a short squeeze - can force liquidations and exponentially magnify your losses.

Other central risks include:

• Loan Costs: Fees and interest rates vary, especially if the asset is hard to borrow or in high demand.
• Capital expenditures: In the stock market, you must pay any dividends distributed during your short period.
• Regulatory uncertainty: Governments may suddenly implement short-selling bans during market crises, forcing you to cover at unfavorable prices.

The duality of the market: Criticism versus defense

Short selling is controversial among investors and politicians. Critics argue that it accelerates market declines and can unfairly harm entire companies - especially their employees and stakeholders. During the financial crisis in 2008, aggressive shorting was so destabilizing that several countries implemented temporary bans.

Supporters, on the other hand, see shorting as a necessary market function that forces companies to be accountable. They point out that it quickly reveals problematic or overvalued companies, which helps the market with self-correction.

To balance these concerns, regulators have introduced rules such as the uptick rule ( which restricts shorting during significant price declines ) and disclosure requirements for large short positions. In the USA, Regulation SHO governs short sales to prevent manipulation and naked shorting.

Overall Assessment

Shorting remains an integral part of both traditional markets and cryptocurrency markets. For traders looking to profit from price declines or hedge risk, it is an important strategy to master. However, not being aware of the enormous risks - unlimited losses, short squeezes, and transaction costs - can lead to catastrophic outcomes. As with any advanced trading technique, shorting requires discipline, risk management, and a complete understanding of the mechanisms behind it.