What Is Short Selling? Hedging and Earning in Bear Markets

Introduction

Traditionally, when you buy a stock, metal, or a cryptocurrency, you expect the market to rise so that the value of your asset may appreciate, and you may earn. However, this is not possible when there is a recession, or the market is in an extended bearish trend. Shorting the market means borrowing an asset and selling it on the expectations of buying it back at a lower price, keeping the profit and returning the asset to the lender. This practice has got currency quite recently but has existed for centuries.

Short Selling as a Hedge

Short selling is a highly useful way to earn money when buying and holding gets risky. Continuous downfall keeps eating away your investment. You can not open a long position because your stop-loss order is likely to get hit, or if you accidentally forget to place a SL, your position may be liquidated. As a protection, or a hedge against depreciation, you can short sell and capitalize the bearish trend. It enables you to cut losses and manage risks because the loss you incur in a spot holding can be compensated by the profit from your short positions.

It is to be kept in mind that short selling is a kind of bet or speculation. You do not “really” buy and sell. Due to this very reason, it is sometimes looked down upon among the traders and general public on account of being responsible for creating fear against the market’s price action. On the other hand, short selling is also admired for being a corrective force for an overbought market and exposing weaknesses of an asset.

As hinted earlier, the notion of short selling dates back to 1600s when people used to speculate against the Dutch East India company. It gained vogue in the bear market starting from 2008.

How Short Selling Works

You might be wondering how you can sell something when you have not bought at first place. Let’s try to understand from a real-life example. Suppose you feel that the price of gold will fall in next few days or weeks, but you yourself do not own any gold. You borrow some gold from someone who demands something as collateral, or a guarantee. You will surrender the collateral to the lender if you fail to return the borrowed gold.

You sell the gold at $3300 and then buy back the same amount in $3000. You are in a position to return the gold and some interest but keep the profit for yourself. But if the price rises, you are in loss, which mounts up when the amount of interest is added. If the lender feels that your loss has increased too much, they keep your collateral.

In crypto trading your own assets in your wallet are your collateral. You keep it with the exchange on which you trade. That’s why, the more your leverage, the more quickly the exchange comes to liquidate your position. But you can be liquidated even if you use no leverage. This happens when the exchange observes that loss is mounting to an extent that you will not be able to pay back.

Suppose you want to open a short position on $ETH which is hovering around $4000. You borrow 1 $ETH for which you start paying interest and trading fee. When the price falls to $3500, you buy it back and return it to the exchange. You have earned $500 from which you will pay the interest and some trading fee and keep the rest for yourself. However, if the price jumps to $4500, you are compelled to buy it back at a loss. If you keep waiting and the price keeps rising, the exchange will jump in to liquidate you.

What is Margin?

Just before liquidation, you usually get a margin call from the exchange. It is necessary to understand what margin is. It is the requirement to open and run a long or short position in futures trading on any exchange. There are two types of margins: initial margin and maintenance margin. Evidently, initial margin is a requirement to start a trade, and maintenance is needed to keep a trade running.

For example, you have got $100 in your future wallet. You want to open a short position with 5x leverage. The exchange will demand $20 collateral. If the price of your coin keeps rising after you enter a short position, your margin will keep shrinking until you get a margin call and liquidated unless you add more funds as maintenance margin.

Advantages and Disadvantages of Short Selling

As with anything, short selling also comes with its own benefits and risks.

The first benefit is the hedge you avail in a bear market. When every asset you buy is biting the dust, you keep on making money through your short positions.

Also, short positions provide liquidity when there is almost no volume in the market.

When deemed controversial, short sellers argue that it helps correct overvalued assets and reveal the loop holes in a market.

The risks include the likelihood of going bankrupt as there is no end to the upside of a coin or a stock. And this was what happened in 2021 when people when short on GameStop, a retail video game company whose stocks were falling rapidly. But a few investors poured in liquidity to lift the price from $20 to $500. Millions were liquidated in that short squeeze.

Sometimes, even your successful trades give you no profit because the profit goes away as trading fees. This happens because in a bear market, short sellers pay fees to long buyers, and in a bullish market, long buyers pay to short sellers.

A lot of controversy surrounds short selling, arguing that it is unethical to spread uncertainty by going short on an asset. It has led to regulations in stock markets, but lack of regulation in the cryptocurrency market keeps the practice controversial.

Conclusion

The sum and substance of the discussion is that short selling is a trade position based on the speculation that the market will fall. It involves borrowing an asset and selling it, only to buy it later on a lower price. Crypto exchanges use investors’ funds as collateral, which get liquidated when the market moves opposite to the betted direction. Short selling is highly risky, but it does provide everyone with an opportunity to make profits in a bear market.