The Basics of Short Selling: How to Profit from Declining Prices?

What do we mean by short selling?

Short selling, or what traders refer to as a “short position,” is fundamentally based on the following logic: we sell an asset today, hoping that we can buy it back later at a lower price. In simpler terms: we are betting on a decrease in price.

However, this strategy is not as simple as a traditional purchase. Short selling works with borrowed funds, which means that the asset is not sold from our own but borrowed from a trading platform, for example, from an exchange or a broker. This mechanism plays a fundamental role in today's financial markets, whether it involves stocks, cryptocurrencies, or other assets.

The Short Position's Opposite: Long vs. Short

A long position is a traditional investment approach: you buy a stock or a Bitcoin and hope that the price will rise. A short position is the opposite of this - you expect the price to decrease.

These two strategies fundamentally determine how financial markets operate. While long investors profit from price increases, short-selling traders do the same from price decreases.

Why Do People Short?

Two main motivations drive short sellers:

1. Speculation: Simply betting on a price decline in the hope of generating profit. This is particularly attractive during a long bear market when prices are continuously falling.

2. Collateral and Risk Mitigation: For example, if you have a large Bitcoin position but are worried about a price drop, you can open a short position on a correlated asset to offset potential losses.

How Does Short Selling Work in Practice?

The basic mechanism is as follows:

1. You provide a collateral ( this is called margin or collateral)
2. You borrow the asset from the platform.
3. You sell it immediately at the current market price.
4. You are waiting for the price to decrease
5. You buy back the asset at a lower price
6. You return the borrowed asset, along with interest.

The profit is the difference between the selling price and the repurchase price after interest payment (.

) Concrete Example: Shorting Bitcoin

Imagine a scenario:

• You borrow 1 BTC at the current price: 100,000 dollars
• You sell this 1 BTC immediately
• The market price of Bitcoin is decreasing to $95,000
• You will buy back 1 BTC for 95,000 dollars
• You will return the borrowed BTC
• Your profit: 5,000 dollars (minus interest and fees)

But what happens if the price rises? If Bitcoin rises to $105,000, then buying back 1 BTC would result in a loss of $5,000, plus additional costs and interest.

Short Selling of Stocks

Another case: an investor believes that the shares of XYZ Corp – which are currently trading at $50 – will decrease. He borrows 100 shares and sells them for $5,000. If the price indeed drops to $40, he can buy back the shares for $4,000, return them, and realize a profit of $1,000 after deducting fees.

Types of Shortselling

There are two main ways to short.

Covered short selling: This is the standard method. You actually borrow an asset and then sell it. This is the most regulated and safer form.

Naked short selling: You sell a security that you have not borrowed first. This is much riskier and is restricted or banned in many places because it represents potential market manipulation.

Requirements for Short Selling: Margin and Collateral

Since short selling requires borrowing, traders must provide collateral (margin-t). This can differ between traditional markets and cryptocurrency markets:

Initial Margin: In traditional stock markets, the initial margin is typically 50% of the value of the shorted stock. In cryptocurrency markets, the requirements are platform-dependent. For example, with 5x leverage, only $200 in collateral is required for a $1,000 position.

Maintenance Margin: Ensures that there is enough money in the account to cover potential losses. If the margin level becomes too low, the platform may issue a margin call requesting additional collateral ###, or simply liquidate your position at an unfavorable price.

The Risks of Short Selling: Why Is It Dangerous?

( 1. Unlimited Loss Potential

This is the most serious risk of shorting. While the loss on a long position is capped at 100% of the original investment ), the loss on a short position is theoretically unlimited. If the price continues to rise, the loss will keep increasing.

( 2. Short Squeeze

A short squeeze is one of the most dangerous phenomena. It occurs when a widely shorted asset suddenly begins to experience a drastic rise in price, trapping the short sellers. The 2021 GameStop case is a classic example of this: retail investors intentionally tried to drive up prices to “squeeze” institutional short sellers, forcing them to close their positions at very high prices.

) 3. Margin Call and Liquidation

If the price rises rapidly and the margin level decreases, the platform may liquidate your position, often at our blurred prices, resulting in significant losses.

( 4. Borrowing Costs

Interest payments and fees, especially for high-demand assets, can quickly escalate. This is particularly true in the stock markets.

) 5. Dividends and Other Obligations

In the stock markets, short sellers are required to pay all dividends that are paid to current owners during the short period. This represents an additional cost.

The Benefits of Shorting

Despite the numerous risks, short selling has real advantages as well:

Profiting in Bear Markets: Allows you to generate profit even when prices are falling – which is impossible with traditional long strategies.

Portfolio Protection: A well-chosen short position can offset losses from long positions, reducing the overall volatility of the portfolio.

Market Efficiency: Some argue that short sellers help uncover overvalued or fraudulent companies, which improves market transparency in the long run.

Increasing Liquidity: Short sellers add demanded supply to the market, which facilitates transactions for other market participants.

Regulation and Ethical Issues

Short selling is a controversial topic. Critics argue that short sellers can contribute to market crashes, especially during crises. During the 2008 financial crisis, several countries temporarily banned short selling. Supporters, however, argue that short selling increases market discipline and prevents overpricing.

Regulators are trying to balance these concerns with measures such as the uptick rule ### you cannot short if the price is falling rapidly ( and information reporting requirements affecting larger short positions. In the United States, the SEC SHO regulation governs short selling to prevent manipulation.

Closing Thoughts on Short Selling

Short selling is a complex but important financial instrument that allows traders and investors to profit from a decline in prices. It can be used for speculative purposes or risk reduction, and it plays a fundamental role in both traditional markets and the world of cryptocurrencies.

However, understanding short selling requires a full recognition of the risks: unlimited loss potential, the danger of a short squeeze, the risk of a margin call, and ongoing interest payments. These efforts are aimed at protecting your capital and making informed decisions in the markets.

Short selling is not a strategy for beginners – it requires adequate knowledge, a risk management plan, and a thorough understanding of the tools offered by the platform for successful implementation.