How to play for declines? A complete guide to shorting

What is short selling and why is it worth understanding

Short selling, known as shorting, is a strategy to make money in markets when prices go down. In practice, it involves selling an asset ( that we first borrow ) and then buying it back at a lower price. The difference between the selling price and the repurchase price is our potential profit. This is not a new idea – short selling strategies appeared as early as the 17th century – but in recent years, they have gained huge popularity among traders and investors worldwide.

Shorting works on virtually every financial market: from the stock exchange, through the currency market, the commodity market, to the cryptocurrency market. Both retail investors and professional trading firms, such as hedge funds, regularly use this strategy.

Game Mechanics on Drops – Step by Step

What does playing for declines look like in practice? Let's imagine that we are convinced that the price of a given asset will fall. Here’s what we do:

1. We provide the required collateral in our margin or futures account.
2. We borrow a specified amount of asset (, for example, from a broker or exchange ).
3. We immediately sell this asset at the current market price.
4. We are waiting for the price drop
5. We repurchase the same amount of the asset at a new, lower price
6. We return the borrowed asset to the lender (together with the interest)

Our profit is the difference between the selling price and the buying price, minus transaction fees and interest on the loan.

Specific examples of playing for drops

Shorting bitcoin in practice

Let's say we borrow 1 BTC and sell it for 100 thousand USD. At this moment we have an open short position and we start paying interest on the loan. If the price of bitcoin drops to 95 thousand USD, we can now buy 1 BTC and return it to the lender. Our profit is 5 thousand USD (minus fees and interest).

Opposite scenario: if the price of bitcoin rises to 105 thousand USD, repurchasing 1 BTC will cost us more than we gained from the sale. The loss will amount to 5 thousand USD plus additional costs.

Short selling stocks – an example with stocks

Let's assume that an investor believes that the shares of company XYZ, listed at $50 per share, are overvalued. He borrows 100 shares and sells them for $5,000. When the price drops to $40, he buys back the shares for $4,000, returns them, and makes a profit of $1,000 (after accounting for fees).

In the opposite case – a rise to 60 USD – the buyback costs 6,000 USD, generating a loss of 1,000 USD plus further financial burdens.

When and why do traders short sell

There are two main reasons why investors take short positions:

Speculation on the recent increase: Traders believe that the asset is overvalued and the price will drop. They want to profit from this.

Wallet Security (hedging): An investor with a long position in similar assets takes a short position elsewhere to offset potential losses. This is a classic risk management strategy in volatile markets.

Technical requirements for shorting

Before we start playing on the declines, we must meet several requirements regarding technical and financial conditions:

Margin deposit (margin): A broker or exchange requires a trader to deposit a certain portion of the position's value. In traditional stock markets, this is usually 50% of the value of shorted securities. In cryptocurrency markets, the requirements vary depending on the platform and the leverage used. With 5× leverage, a position worth 1000 USD requires a 200 USD deposit.

Mandatory margin deposit (maintenance margin): Ensures that the account has sufficient funds to cover potential losses. It is usually calculated as the ratio of assets to liabilities.

Liquidation Risk: If the deposit falls below the required level, the broker may issue a margin call or automatically close the position to cover the borrowed funds. This can lead to significant losses.

Advantages of Playing on Drops for Investors

Shorting offers investors a number of potential benefits:

• Making money in a bear market: While most traders lose money during downturns, short sellers can profit.
• Strategic flexibility: Short players can protect their portfolios by taking positions that offset losses on long investments.
• Correcting valuations: Short selling helps identify and eliminate overvalued assets from the market.
• Increased liquidity: More trading activity makes it easier for other market participants to execute transactions at satisfactory prices.

Risks Associated with Short Selling

This is where the dark side of shorting begins. The risks can be serious and significant:

Theoretically unlimited losses: In a long position, the maximum loss is 100% of the investment. In short selling, the price can rise infinitely, which theoretically means unlimited losses. Over the years, many professional traders have gone bankrupt due to short selling.

Short Squeeze (short squeeze): When the price rises sharply due to unexpected news or market minority, short sellers may be forced to close their positions at a loss.

Borrowing Costs: Fees and interest on loans are variable and may increase, particularly for high-demand assets that are difficult to borrow.

Dividend obligations: In the stock market, short sellers must cover any dividends paid during the duration of the short position.

Regulatory Restrictions: During market crises, regulatory authorities may temporarily prohibit or restrict short selling, forcing players to close positions at unfavorable prices.

Types of Short Selling – Technical Differences

Covered Short Selling (covered short): The trader actually borrows and sells the asset. This is the most common and safer method, widely used in traditional and cryptocurrency markets.

Naked short selling (naked short): Selling an asset without borrowing it first. This method is riskier and is often restricted or prohibited due to the risks it poses to market stability.

Ethical and Regulatory Aspects of Short Selling

Short selling raises considerable controversy. Critics argue that aggressive short selling can deepen market declines and unfairly target companies, potentially harming employees. During the financial crisis of 2008, the governments of several countries temporarily banned short selling.

Supporters argue that shorting increases market transparency by exposing overvalued or questionable companies. Regulatory authorities are trying to find a balance through regulations such as the uptick rule (uptick rule), which restricts shorting during sharp declines.

In the USA, short selling is subject to the SHO regulation issued by the SEC, which prevents manipulation and unfair practices.

Summary – is it worth betting on declines

Short selling is a legitimate strategy for making money in the markets, available to both speculators looking for profit and investors pragmatically managing risk. Shorting has been successfully functioning in traditional and cryptocurrency financial markets for decades.

However, anyone considering short selling must understand the associated risks: unlimited potential losses, short squeezes, variable borrowing costs, and regulatory threats. This is not a strategy for beginners – it requires experience, discipline, and proper risk management. Before deciding to short sell, it's advisable to seek advice from an experienced financial advisor.