Short selling: A trading tool to profit from declines

Financial markets offer traders numerous opportunities. Some focus on long positions, waiting for price increases to sell for profit. However, experienced traders employ a different approach – short selling. This strategy allows profit from declining prices, turning market downturns into potential opportunities. Have you ever wondered how traders can profit when the market falls?

Mechanics of Short Selling: How It Works in Practice

Short selling means selling an asset you do not currently own, hoping to buy it back later at a lower price and thus make a profit. The process begins with borrowing. The trader borrows assets (such as stocks or cryptocurrencies), sells them at the current market price, and waits for the price to drop. If the price indeed falls, they buy back the same assets at the lower price and return them to the lender, pocketing the difference.

For example, take Bitcoin. If a trader predicts BTC’s price will decline, they borrow 1 BTC, which costs $100,000, and sell it immediately. If BTC’s price then drops to $95,000, the trader can buy back 1 BTC at this lower price and return it to the lender. After deducting costs (interest, transaction fees), they keep approximately $5,000 profit—assuming the market behaves as expected.

The process is similar in stock markets. An investor who believes a stock currently trading at $50 will decline might borrow 100 shares (worth $5,000), sell them immediately, and wait. If the price drops to $40, they buy back 100 shares for $4,000 and return them to the lender. After costs (borrowing fees, interest), the profit is roughly $1,000.

Covered and Naked Short Selling: Two Different Models

There are two main variants of short selling that traders choose between.

Covered short selling is the standard and safer practice. Here, the trader borrows the assets, sells them, and then buys them back later. The exchange or broker ensures the assets are available before the sale. This is common on stock and crypto markets and is considered the typical method.

Naked short selling involves selling assets without borrowing them first. This riskier approach can lead to market manipulation and chaos, which is why many jurisdictions restrict or prohibit it.

Collateral and Financed Positions: Costs of Short Selling

Short selling involves costs and requirements related to financed positions. The trader must provide an initial margin. Typically, stock exchanges require about 50% of the value of the shorted asset. Cryptocurrency platforms vary in their requirements depending on leverage used. For example, a $1,000 position with fivefold leverage requires about $200 in collateral.

But that’s not all. The trader must monitor maintenance margin—a constantly changing requirement ensuring sufficient funds are available to cover potential losses. If the margin falls too low (for example, due to a price increase), a margin call is triggered. The broker then demands additional funds or liquidates existing positions to reduce risk. This can lead to significant losses, especially in volatile markets.

Additionally, interest payments are incurred on borrowed assets, along with platform or broker fees. Borrowing rare or highly demanded securities can be expensive.

Why Traders Engage in Short Selling

Short selling offers traders and investors several practical advantages.

Profit from declining markets. Traditional traders who only go long are limited to gains when prices rise. Short selling turns losses into opportunities—traders can profit even when the entire market declines or a specific asset devalues. This is a significant advantage during volatile times.

Risk hedging. In an investment portfolio, short selling can serve as protection. If an investor holds long positions but fears a market downturn, they can establish short positions. This is called hedging—long positions are protected. Potential losses in one position can be offset by gains in the other.

Market efficiency. Market theorists argue that short sellers help expose overvalued and fraudulent companies, bringing negative information to light. This improves market transparency and helps prices reflect true value.

Trading activity. Short selling increases trading volume and liquidity, making it easier for buyers and sellers to execute transactions.

Risks and Downsides of Short Selling: What You Need to Know

Short selling is not risk-free. In fact, it is one of the riskiest strategies in the financial markets.

Unlimited potential losses. This is the biggest risk of short selling. While a long position can only lose the invested amount (if the asset drops to zero), a short position has no upper limit. If the price rises from $100 to $200, then $500, then $1,000, and so on—potential losses grow indefinitely. Many professional traders have gone bankrupt by underestimating the potential for price increases.

Short squeeze. Going against the market. If the price rises as expected, other investors may notice short sellers and buy shares actively to push the price higher. A rapid increase can force short sellers to cover at a loss, amplifying the upward move and causing significant losses.

Borrowing costs. The lender (usually the exchange or broker) charges interest and fees for lending the assets. Rare or highly demanded stocks can be expensive to borrow, eating into profits.

Dividends. Short sellers must pay dividends issued during the short period, increasing costs.

Liquidation risk and margin calls. If the price rises and the margin falls below required levels, the broker can force the trader to cover losses by liquidating positions. Difficulties in meeting margin calls during volatile periods can lead to large losses.

Broader Market Perspective: Regulation and Ethical Issues

Short selling has long been controversial.

Critics’ view: They argue that aggressive short selling can deepen market declines, especially during crises. During the 2008 financial crisis, many countries temporarily banned short selling to prevent further damage. Critics also say short sellers target specific companies, spreading negative rumors and harming employees and stakeholders.

Supporters’ view: They emphasize that short selling increases market transparency. Aggressive short sellers have uncovered frauds like Enron, Wirecard, and others that regulators missed. Without short selling, such scams might remain hidden longer.

Regulation and balance: Regulators try to balance these concerns. Many markets implement rules like the uptick rule, which restricts short selling during rapid price declines to prevent excessive speculation. The U.S. SEC’s Regulation SHO governs naked short selling and requires disclosure of large short positions.

Short Selling Today: Growing in Stocks and Cryptocurrencies

Short selling originated in the 17th century on the Dutch stock exchange. Today, it is an integral part of stock, commodity, currency, and even crypto markets.

With Bitcoin trading around $67,580, crypto traders have the opportunity to short sell. Platforms like Gate.io offer margin and futures trading, enabling traders to establish short positions. This has created dynamics similar to traditional markets.

Retail investors and professional hedge funds use short selling for speculation and portfolio hedging. The 2021 GameStop short squeeze demonstrated how retail investors organized on Reddit to pressure short sellers, bringing short selling back into the spotlight.

Final Thoughts: What to Keep in Mind

Short selling is a powerful trading tool that, when used correctly, can generate profits in falling markets and reduce portfolio risk. However, it is not suitable for beginners. The potential for unlimited losses, short squeezes, borrowing costs, and liquidation risks make it a long-term strategy requiring careful planning and monitoring.

Before engaging in short selling, you should understand the risks, maintain sufficient collateral, familiarize yourself with your jurisdiction’s regulations, and consult financial advisors if possible. Short selling is not gambling—it’s a strategy that demands knowledge, discipline, and good risk management.

Is short selling the right path for you? The answer depends on your trading style, risk tolerance, and market outlook. But now that you understand the mechanics, risks, and opportunities, you are better prepared to make informed decisions.