Shorting - Profit in declining markets? Here's how theory and practice work.

What is short selling actually?

Short selling ( is a trading strategy that allows speculation on the decline of asset prices. The essence is simple: we sell an asset with the intention of buying it back later at a lower price. This “sell-buyback” logic enables traders to generate profit even when the markets are falling.

Short selling is not a new phenomenon - its origins date back to the 17th century Dutch stock exchange. However, in the past decade, particularly since the 2008 financial crisis and the 2021 GameStop event, it has significantly gained prominence in the vocabulary and the awareness of investors.

Why and how does a trader short?

There can be fundamentally two reasons for short selling:

Speculation: Betting on a price decline in hopes of profit. If you believe that an asset is overvalued and the price will fall, shorting can be a means to take advantage of this.

Protection: Reducing the risks of other portfolio positions. If you have long )long( positions, shorting is a hedging strategy that offsets potential losses.

How does the practicum work?

Suppose you are pessimistic about an asset. The first step is to place sufficient collateral )collateral(. After that, you borrow a certain amount of the asset and immediately sell it at the current market price. This is the moment you open a short position - you have an open obligation.

If the market moves as you envision and the price decreases, you buy back the same amount that you borrowed and return it to the lender. The difference between the original selling price and the buyback price is your potential profit - minus transaction fees and interest costs.

) Practical example: Shorting Bitcoin

You borrow 1 bitcoin ###BTC( and sell it for $100,000. You pay interest on this position while it remains open. If the price of Bitcoin drops to $95,000, you buy back 1 BTC at the same price and return it to the lender. Net profit: $5,000 after )interest and fees(.

But what happens in the opposite scenario? If the price rises to $105,000, you will realize a loss of $5,000, plus the cost of accrued interest and fees.

Types of Short Selling

Covered short selling )covered short(: The actual borrowing and selling of the asset. This is the standard and widely accepted practice.

Naked shorting ): Selling an asset without first borrowing it. It is practically subject to legal restrictions or prohibitions, as it can lead to potential market manipulation.

Margin and collateral requirements

Short selling operates through borrowing, so you need to provide collateral or margin. The conditions vary by asset and platform:

• Initial margin: In traditional stock markets, it is usually 50% of the asset's value. However, on cryptocurrency platforms, it depends on the constraints of the requirements, the platform, and the leverage applied. For example, with 5x leverage, a position of $1,000 requires $200 in collateral.

• Maintenance margin: Ensures that your account has sufficient liquidity for potential losses. This is usually calculated based on the margin level, which is the ratio of total assets to total liabilities.

• Margin call and liquidation: If the margin level falls too low, the platform may issue a margin call - after this, you either need to add deposits, or your positions will be automatically liquidated. The latter can lead to dramatic losses.

The advantages of shorting

• Profiting in Declining Markets: Allows traders to make money even when the markets are falling.

• Portfolio Protection: Offsetting losses in your long positions.

• Market efficiency: According to several analysts, short sellers help bring overpriced or damaged assets back to their correct levels.

• Liquidity expansion: Increases trading activity and asset mobility.

The Risks and Disadvantages of Short Selling

It's important to keep in mind: the theoretical loss of a short position is unlimited. While in a long position you can lose at most 100% when the asset drops to zero, in shorting, the price can rise infinitely high.

Short squeeze risk: If the price suddenly jumps (for example due to news), short sellers may get “trapped”. The rising price may force them to close positions at a loss. This can create a self-reinforcing cycle where the price goes even higher.

Other disadvantages:

• Borrowing Costs: Interest rates and fees are variable and may be higher for illiquid or popular assets.

• Dividend payment obligation: In the stock markets, the short seller must pay the dividends that are paid during the short period.

• Regulatory Restrictions: During market stress, short selling may be temporarily prohibited or restricted, which can be unfavorable in certain situations.

Market Perspective and Ethical Questions

Short selling is a controversial strategy. Critics argue that it can exacerbate market downturns or unfairly depress certain companies. During the 2008 crisis, several countries temporarily banned it.

Supporters, however, emphasize that short-selling exposes overvalued or fraudulent companies, improving market integrity.

Regulators are trying to create balance with measures such as the uptick rule (uptick rule), which limits short selling during steep declines, as well as disclosure requirements affecting large short positions.

What you need to know before shorting?

Before shorting, assess the risks and costs. A survey of market direction can bankrupt too many investors. A solid risk management strategy is necessary: limit losses, know your exit points, and never short with your entire portfolio.

Shorting is a powerful tool that can be useful with the right preparation and discipline. However, beginners are advised to start with smaller positions until they fully understand the mechanism and the risks.

Closing thoughts

Short selling is an integral part of modern markets - it allows traders to profit even in declining markets and can serve as a hedging strategy. But like any trading tool, short selling comes with risks: the possibility of unlimited losses, short squeezes, interest costs, and often unfavorable regulations.

Education and learning from more experienced traders is crucial before you start with this more complex strategy. It's also important to understand that shorting is neither bad nor good in itself - it depends on the application and the timing.

Disclaimer: This content is provided for general informational and educational purposes only. It does not constitute financial, legal, or investment advice. The trader is solely responsible for any losses incurred in trading. It is necessary to seek advice from qualified professionals.