The mechanism of generating profit through short selling: From the basics of the Short strategy to practical implementation

What is Short

Short selling is a trading strategy aimed at selling an asset and then buying it back at a lower price later. It is practiced in almost all financial markets, including Bitcoin, stocks, and foreign exchange. Unlike a regular long position (buy position), it allows traders to profit even in a declining price environment, making it popular among traders looking to capitalize on market downtrends.

The origin of short selling dates back to the 17th century Dutch stock market. It has been an important trading method that has attracted attention during historical market fluctuations, such as the 2008 financial crisis and the 2021 GameStop short squeeze.

How Short Selling Works

The process of opening a Short position is relatively simple. First, a trader who expects a specific asset to decrease in value borrows that asset. The borrowed asset is immediately sold at the current market price, and the trader waits for the price to drop. If the market declines as expected, the trader buys back the asset at a lower price and returns the original quantity to the lender (with interest), resulting in profit from the difference between the selling amount and the buyback amount.

For example, let's say you borrowed 1 BTC at $100,000 and sold it. If the price of Bitcoin drops to $95,000, buying back 1 BTC to return it would result in a profit of $5,000. However, you need to deduct the borrowing fees and interest from this profit.

It functions similarly in stocks as well. Suppose a trader predicts that the stock price of XYZ Corp is currently $50, borrows 100 shares, and sells them for $5,000. If the stock price drops to $40, the investor can buy them back for $4,000 and gain a profit of $1,000 (after deducting fees).

Purpose and Classification of Short Selling

The usage of Short can be broadly divided into two categories.

For speculative purposes, traders aim to profit by predicting price declines. For hedging purposes, it functions as a defense mechanism to offset losses from existing long positions and protect the overall portfolio from risk.

There are two methods to execute short selling. Covered Short is the standard method of selling by borrowing actual assets, while Naked Short is the method of selling without borrowing assets. Naked Short carries extremely high risks and is restricted or illegal in many markets due to the potential for market manipulation.

Conditions Required for Short Trading

To utilize borrowed funds for a short, it is usually necessary to prepare collateral through a margin or futures account. There are three important requirements.

Initial margin is typically about 50% of the value of the short-sold stock in traditional markets. In the cryptocurrency market, it varies depending on the platform and leverage. For example, when using 5x leverage, a $1,000 position requires $200 in collateral.

Maintenance margin ensures that the account holds sufficient funds to cover potential losses. It is typically calculated based on the trader's margin level (total assets ÷ total liabilities).

Liquidation risk occurs when the margin level drops excessively. Brokers and exchanges may trigger a margin call, requiring additional funds to be deposited, or may automatically force the liquidation of positions, which can lead to significant losses.

Advantages of Short Selling Strategy

Short provides investors with multiple advantages.

Monetization in a declining market is the biggest advantage. Even in a bear market where traditional long-only strategies cannot yield profits, you can leverage price declines to generate revenue.

A hedge mechanism that functions as portfolio protection is also important. Especially in a highly volatile market environment, it offsets losses from long positions and protects the overall assets.

There are also indications that contribute to improving market efficiency. By reflecting overvalued assets and overlooked negative information in market prices through Short, the price discovery mechanism is enhanced.

An increase in liquidity is also a secondary benefit, as active trading activities make it easier for buyers and sellers to transact.

Risks Associated with Short Selling

The biggest risk of a Short position is that, theoretically, the losses can become infinite. While the maximum loss for a Long position is limited to the amount invested, in a Short position, there is no limit to how much the price can rise, therefore losses can potentially expand without bounds.

Short squeeze is a significant risk that has historically bankrupted many traders. When asset prices surge due to unexpected news or events, traders who are short can find themselves caught in a “trap” and cornered.

Other important risk factors include the following.

Borrowing costs are variable. In cases where demand is high and borrowing assets are difficult, fees and interest may surge.

Dividend payment obligations are specific to the stock market. During the short period, the seller is responsible for paying the dividends, which can lead to unexpected cost increases.

Regulatory risks also exist. If short selling is temporarily banned or restricted during market turmoil, sellers may be forced to liquidate their positions at unfavorable prices.

Debate on Market and Ethics

Short has generated various debates. Critics point out that shorting can accelerate market declines and unfairly target companies, causing harm to employees and stakeholders. During the 2008 financial crisis, aggressive shorting became the subject of temporary bans in several countries.

On the other hand, supporters present the argument that short selling exposes overvalued companies and fraudulent enterprises, thereby enhancing market transparency and integrity.

Regulators are addressing these concerns by limiting short selling during sharp declines with the uptick rule and introducing large short position disclosure requirements. The U.S. SEC Regulation SHO clearly prohibits actions such as naked short selling.

Summary of Short Selling Strategies

Short is an established trading method that generates profit from price declines. Whether for speculative purposes or hedging, short continues to play an important role in both traditional financial markets and the cryptocurrency market.

When utilizing this strategy, it is essential to fully understand the inherent risks and disadvantages, such as the potential for unlimited losses, short squeezes, and trading costs. Only with careful risk management and market analysis can short selling become an effective portfolio management tool.