What Is Shorting and How Do You Make a Profit From a Short Position

In this article, we'll look at what shorting (short selling) is and how you can make a profit through a short position. Using a Bitcoin exchange as an example, we'll also walk through how to open a short yourself and explain why shorting is risky.

Introduction

There are many ways to make money in the market. Some traders use technical analysis, while others do ultra-short-term scalping.

But how can you make a profit in a bear market, when prices keep falling over the long term? In that case, you can open a short position and profit from the price drop. A short position can also be a great risk management and hedging tool that protects the value of your holdings against falling prices.

However, the losses on a short position are potentially unlimited, and they can wipe out all the assets in your account through liquidation, so you need to be especially careful and attentive.

What Is Shorting?

Shorting (or short selling) is a position strategy that profits from a fall in an asset's price. Normally, you make money when an asset's price goes up, but shorting works the other way around.

The opposite of a short position is a long position, which is basically a strategy that profits from a rise in an asset's price.

Shorting is easy to find in almost every financial market, including stocks, crypto assets, commodities and foreign exchange. It's also called short selling or going inverse. It is often used by some retail investors and by professional trading firms such as hedge funds.

Hedging With Shorts

You usually open a short to profit from a fall in an asset's price, but you can also open one separately to protect the value of your assets.

You can open a short to hedge a long position or the value of your holdings. For example, if you hold a call option (a buy position), you can open a short against that position to lock in your profit.

Or, if you want to limit downside losses on stocks or coins you hold without actually selling them, you can open a short on a related asset.

Naked Shorts and Covered Shorts

There are two types of short positions: naked shorts and covered shorts. A naked short is short selling in which the trader sells an asset without actually holding it. However, naked short selling of stocks is illegal in the United States, and Korea recently banned short selling entirely.

A covered short means the trader holds or borrows the stocks or coins first and then opens a short position. If you open a short with borrowed assets, you pay interest until you repay the loan.

How Does a Short Make Money?

For example, let's say you opened a short position when Bitcoin was at $30,000. If the price keeps falling until 1 BTC is worth $10,000, you can close the short position and realize a profit equal to the percentage the price dropped.

A short makes a profit on the same principle as a spot holding or a long position. The only difference is that the price has to fall for you to profit. In other words, for a short position, the entry price is the selling price and the exit price is the buying price.

Good Times to Open a Short

Timing is extremely important in shorting, because stocks and coins generally fall much faster than they rise. That means short traders need to time their trades as close to perfectly as possible.

If you short too late, the asset has already fallen a lot and may bounce back. On the other hand, if you short too early, rising prices can make it hard to hold on to your short position.

Here are four moments worth considering as good times to open a short position.

• In a bear market: When the market falls quickly and keeps falling, as in the 2008–09 global bear market, you can make a profit by shorting.
• When an asset's or the market's fundamentals worsen: You can open a short by looking for moments when a decline could be triggered, for example by falling business performance or interest rate hikes.
• When technical indicators confirm a bearish trend: You can try shorting when technical signals appear, such as a break below long-term support or a death cross.
• When market sentiment is overheated: You can try shorting when the mood around a specific sector or the whole market is overly optimistic and the overall market is overvalued as a result.

How to Open a Short Position

Short positions are usually opened through margin trading, using margin assets instead of holding the asset directly. That's why shorting is closely tied to derivatives such as margin and futures trading. So how do you open a short position?

Beginner investors are better off not shorting until they have more trading experience. This is only a general explanation of how to short, and opening short positions carelessly can be very risky.

Let's use Binance, the world's largest crypto exchange, as an example. Here's how to short Bitcoin on Binance.

1. Go to Binance Futures.
2. Choose between perpetual and quarterly futures contracts.
3. Read the Binance Futures guide to understand how the platform works.
4. Go to the futures trading page for the crypto asset you want and set your leverage and margin.
5. Open a short position.

The Risks of Short Positions

There are several factors to consider before opening a short position. One of them is that, in theory, a short position can lose an unlimited amount. That's because there is no cap on how high an asset's price can rise.

If unexpected good news breaks and the price rises, a short squeeze (covering) can occur and your position may be liquidated in an instant. So when you open a short position, it's a good idea to set a stop loss and plan your position's invalidation point in advance.

Is Shorting Bad?

Some people criticize short selling as a bet that drives markets down. However, many economists argue that shorting makes markets more efficient and stable.

Technical traders and analysts often get trading ideas by looking at the short ratio and interest rates related to short positions on an asset. However, you need to be careful, because large short positions can come under pressure from margin calls.

Conclusion

Basically, a short position is a bet that a market or asset will weaken. When you open a short position, you can usually do so without holding the asset directly.

Because you can profit when an asset's price falls, shorting may look like an attractive strategy. However, you need to be especially careful, since you could suffer huge losses if the asset's price rebounds or a short squeeze occurs.