When the stock market became more accessible to curious participants in the early 20th Century, the prevailing mantra for newcomers was best crystalized as: buy low and sell high.
However, there are numerous ways to potentially raise capital by trading both traditional and digital assets. Some traders will consult white papers and internal documents before committing to a company’s stock or token, while others employ technical analysis to find entry and exit points in the market.
While prevailing strategies tend to show more direct correlations to gains during a bull market, traders can also choose to deploy techniques that attempt to capitalize on falling prices.
Here’s where short selling comes into play.
Follow along as we unpack how this trading tactic works, and when it could potentially be used to navigate less favorable conditions along your crypto journey.
What is shorting?
Shorting, or short selling, is when a trader sells a security or asset with the intention of buying it back later at a lower price. Traders decide to short sell when they believe that the price is more likely to drop in the near future, than rise. So, instead of exposing their holdings to the downside of a bear market, traders short sell with the intention of protecting the fiat denominated value of their stocks or tokens.
Although it’s considered an advanced trading strategy, shorting is a common maneuver for retail investors and professional trading firms alike, to help remain potentially solvent during bear markets.
How does shorting work?
In practice, short selling works by borrowing an asset first, selling it, and then repurchasing that asset later at a lower price. If a trader manages to repurchase the asset at a lower price, they can return it to the broker they borrowed it from to receive a profit.
For instance, let’s say a trader is feeling bearish on Bitcoin. In this situation, the trader could elect to short sell, let’s say, a $5,000 BTC position with the expectation to repurchase it for $3,000 at a later date. The trader will need to put up some amount of collateral with their broker to cover the $5,000 in BTC. The broker will then lend them BTC, which the trader then sells immediately. At this point, they have an open short position on BTC.
If the crypto market moves as they expected, the trader will have the opportunity to buy back their BTC at $3,000 and return it to their broker. In this scenario, the trader would receive $2,000 in profit, which represents the difference between the initial sale price of their BTC, and the price at which they reacquired their assets.
However, it’s worth noting the hypothetical profit in this instance does not reflect the interest and fees charged by most brokers. To calculate net profit, simply deduct fees and interest from the $2,000 profit.
Why would a trader want to short a position?
Selling first and then buying later at a lower price has several theoretical advantages:
- Markets tend to drop faster than they recover. Therefore, traders may have the opportunity to make a quick buck by short selling in a bear market, as opposed to buying in the middle of a bull run.
- Good offense can prove defensive. Shorting allows traders to potentially hedge their long positions by giving them the chance to preserve capital during bear markets.
- Diversity breeds innovation. To a hammer, everything looks like a nail. However, having an array of available tools can help traders react to a wider set of market conditions with greater precision.
The risks of shorting
Like most techniques in the market, short selling is not without its… shortcomings. To fully understand this tactic, novice traders should first educate themselves about the potential downsides and disadvantages before putting their assets on the line.
For instance, if the price of a crypto asset or stock rises, a trader could become trapped in a short position where their potential for loss is infinite. Like being reluctantly tied to the end of a financial rocket, this can cause collateral to be liquidated (sold) to cover the costs, or result in traders falling into debt to their brokers.
While less catastrophic than an unplanned trip to the moon, short selling can also incur more fees than other trading tactics. That’s why it’s always important to conduct a full risk assessment prior to entering any new financial situation that could prove detrimental to your holdings.
Understanding shorting, how it works, and knowing when to use such a tactic comes with time, careful research, and a hearty appetite for risk. Yet despite these caveats, shorting can be a viable strategy to preserve capital in a bear market without holding the underlying asset.
As always, take the time to research and understand the risks associated with attempting more advanced trading tactics. For more information, head over to CEX.IO University to access a wide array of educational materials to aid in your crypto journey.