Learn how short selling works, its risks, and its common use cases.
Short selling or 'shorting' is a trading strategy used to speculate on the decline in price of an asset. When you short something, you are in effect borrowing an asset and selling it with the expectation that you can buy it back later for a lower price. Because you are selling an asset you don't actually own, you must borrow it on margin. If your bet about price declining turns out correct, you will profit from the difference between the amount you sold it for and the lower amount you later buy it back at (minus any commission and/or interest charged to the margin account).
By shorting, you are selling to open and buying to close. This means you are opening a position by first selling the asset in question, then later unwinding it by buying that asset back.
Given the above definition of short-selling, its chief risk becomes readily apparent. Namely, that while an asset's price can only experience so much downside (in other words, it cannot go lower than zero), it can theoretically experience infinite upside.
What this means from a practical trading standpoint is that if you decide to short an asset and, instead of the price decreasing like you expect, it increases, your potential loss is unlimited. In such a case, you are caught on the 'wrong side' of the trade because, at some point, you must re-buy the asset you borrowed. The more the price of the asset increases, the more losses you will incur as you are forced to buy it back at the new, higher price.
This is where the importance of risk management comes into play. By setting a limit order at a level where you deem your thesis for the trade is wrong, you can limit your downside and protect your collateral.
So, with the risks involved with shorting, why would someone choose to do it?
While advanced traders may have complicated strategies involving shorting, the majority of short selling is motivated by one of two reasons:
Many traders don't necessarily care whether or not an asset's price goes up or down, so long as they can profit from the volatility in either direction. By short selling an asset, a trader is able to capture profit from a decline in that asset's price. This gives them a more versatile tool set to capture profit, as they are able to speculate on price moving in either direction.
Hedging is a strategy used to protect the gains and minimize the losses of a portfolio. Short selling can be employed as a hedge by using it to balance long positions in a portfolio. Think of it as a sort of insurance policy should the price of an asset decrease. While this would negatively affect the price of the portfolio's long positions, it would result in profit for the short positions, providing some risk protection.
Shorting uses borrowed money
Because shorting involves the sale of an asset you don't actually own, it must be done on margin. This normally entails the payment of margin interest. When it comes to shorting using perpetual futures contracts, you either pay or earn a funding rate–same with long positions. The amount of funding rate paid depends on market conditions as well as how the exchange you're using calculates it. To learn more about perpetual futures contracts and funding rates, check out this learn article.
Like any trade placed on margin, open short positions have the potential to result in liquidation. For short selling, this occurs when the asset's price rises to such a degree that it cannot be covered by the position's margin. When this happens, the margin is liquidated and used to buy back the borrowed asset, unwinding the position.
We have another article on the topic of liquidation (and how to avoid it). You can read it here.
When used properly, short selling is a powerful compliment to a trader’s toolset. It allows you to speculate on price movement in either direction, and provides the ability to hedge your portfolio.