What Is Shorting in the Financial Markets?
Introduction
In the world of financial markets, there are a number of different ways to generate profits. While some traders will use technical analysis to predict market movements, others will utilize fundamental analysis to determine the value of companies and projects. Due to this fact, as a trader or investor, you are also able to create many different trading strategies that will help you make profit.
In contrast, what if the market is experiencing a prolonged bear market, where there is a constant decline in prices? What options do traders have then in order to still continue to make money from trading? Traders can short the market in order to profit from price declines. An excellent method for managing risk and hedging existing holdings is to take a short position.
What is shorting?
An asset is shorted (or sold short) when an asset is sold with the hopes of repurchasing it later at a lower price. In short positions, the trader is optimistic that the asset's price will decrease, which means that they are "bearish" about that particular asset. Rather than just holding and waiting for an asset's price to go up, some traders adopt the short selling strategy as a way of generating a profit from a decrease in its value. In other words, short selling is one of the best ways to preserve capital during a decline in price.
A short market is one in which one shorts something on the market, regardless of whether it is a stock market, a commodity market, a forex market, or a cryptocurrency market. Therefore, short sales are widely used by both retail investors and professional traders, such as hedge funds. The short sale of stocks or cryptocurrencies is a common strategy for long-term and short-term investors. Buying a long position is the opposite of a short position, in which a trader invests in an asset in hopes that it will gain in value .
How does shorting work?
A short sale usually occurs when funds are borrowed, though this does not happen in all cases. In this case, you would be effectively shorting bitcoin if you sold some of your spot Bitcoin position at $10,000 with a plan to rebuy it later at $8,000. In addition, borrowing money to short a position is another common practice. Therefore, shorting is closely related to margin trading, futures contracts, and other derivative products such as options and futures contracts. Let's take a look at how it works.
In the case where you're bearish on a financial instrument, like a stock or a cryptocurrency. As soon as you provide the needed collateral, you take out a loan on that asset and sell it as soon as it is paid back. Then, you have a short position open on the asset. You will borrow the same amount again if the market fulfills your expectations and goes lower, and then you will pay it back to your lender (plus interest). Profit is the difference between the price you originally sold and the price you repurchased.
Let us now look at an example in more detail. A borrower borrows 1 bitcoin and sells it at 8,000 dollars. You now have a short position in 1 BTC for which you are paying interest. Suppose the market price of Bitcoin drops to $6,000 . You purchase one Bitcoin (BTC) and return that one Bitcoin (BTC) to the lender (usually, the exchange). Assuming that this case is true, your profit in this scenario would be $2,000 (minus the interest payment and other fees).
The risks of shorting
Investing in a short position entails a number of risks, so it is important to take the time to consider them before you do. One of the problems with short positions is that the potential loss is infinite. The shorting of a stock has lead to numerous bankruptcies for professional traders over the past few decades. When the stock price jumps because of some unexpected news, short sellers can quickly find themselves "trapped" in the price increase.
In short, when you go long on the spot market, how much is your potential loss? It all depends on the size of the position you take. In the case where you buy one bitcoin at $10,000 and the Bitcoin price falls to zero, the absolute worst thing that could happen is that you have lost your initial investment. What happens, however, when you short Bitcoin on a margin trading platform? In this case, your downside is unlimited. But why? That's because the price may go up in an infinite amount. Contrary to this, your price cannot drop below 0 when you are long.
You will always incur losses if you are shorting an asset borrowed from the bank and the price of the asset keeps increasing. As such, this is more of a theoretical risk than it is a practical one since the majority of platforms will liquidate your position well before you reach a negative balance. But it's important to keep this in mind, since it shows why it's vital that you always keep a close eye on margin requirements, and that you always use a stop-loss to protect your gains.
Shorting follows the standard principles of risk management. Be sure you protect your downside. Use a stop-loss, consider your position sizing, and ensure that you understand what the risks are associated with liquidation.