Short selling is amongst the trading terms that confuse a lot of beginners so in this article, we’ll tell you what it is, how and when to use as well as its pros & cons.
Short selling (or shorting) is the sale of an asset or instrument that you’ve borrowed from your broker (using margin trading) and that you can buy back later at a lower price and therefore make a profit. It is the opposite of going long which consists of buying an asset and sell it when it’s value went up. Almost any securities can be shorted. That includes: stocks, bonds, currencies, cryptocurrencies or commodities.
How and When?
To short sell any instrument, simply go to your broker and instead of buying like you would normally do, just press sell first and there you go. You’ve now shorted because you believe the price will decline and therefore will be able to buy it back from yourself later on and hopefully make a profit.
As with any trading decisions, shorting should be performed after having done a thorough technical analysis of the market. If you’re not familiar with the main trading tools and indicators that are used in technical analysis, we strongly recommend you to check out our lesson on this matter.
Shorting is usually used by traders when the market has reached an all time high or a strong resistance. Let’s use the following BTC/USD chart as an example.
As we can see here when Bitcoin reached nearly $20,000 mid December 2017, it was massively overbough as the RSI was around 90 and was way beyond the 18 average of highs. These are amongst the signs traders look for to identify a potential trend reversal and therefore placing their short positions. Clearly, shorting BTC at $20,000 turned out to be very profitable as the price reached $6,000 at its lowest.
Pros & Cons
The great thing about shorting is that you can make profit while being in a correction phase or a bear market. Therefore, if you make the right calls, you can make money when the market goes up going long and when the market goes down going short. You can also use short selling to hedge and therefore minimize the downside risk of a long position.
There is however one main drawback to shorting and it’s a big one. When you short sell, your losses can potentially be infinite since there is no upper limit to an asset’s price appreciation. This can get out of hand very quickly as you should remember that you initially borrowed the asset from your broker using margin trading. Just as when you go long on margin, you must meet a certain minimum maintenance requirement. If your account falls below, you will need to put in more cash or liquidate your position. That’s why we strongly recommend you to be careful with this strategy and understand the risks involved before taking any action.