The core mechanism of short-term trading: a deep analysis of shorting and risk management

From Reverse Operations to Profit Acquisition: The Essence of Shorting

Shorting (also known as short selling or short-term selling) is a trading method that profits when asset prices fall. In simple terms, you borrow an asset, sell it immediately, and then wait for the price to drop before buying it back at a lower price and returning it to the lender. This strategy is completely opposite to the traditional “buy low, sell high” mindset—you sell first and then buy.

This strategy is widely present in the stock, commodity futures, foreign exchange, and cryptocurrency markets. Whether retail investors or professional investment institutions (such as hedge funds), they will use shorting to seek profit opportunities in bear markets. Correspondingly, there is going long (bullish), which involves buying assets in anticipation of price increases.

Why Traders Choose Shorting

Traders adopt short strategies for two main purposes:

Speculative Profit: Directly betting that an asset will fall, profiting from the price decline. For example, if you think a certain stock will drop from $100 to $80, you can borrow and sell it, then buy it back when it reaches the expected price, earning a $20 difference.

Risk Hedging: If you already have a long position in a certain asset, you can lock in risks and compensate for potential losses by shorting related or similar assets. This is a common risk management strategy used by institutional investors.

How Shorting Actually Works

The actual operation process is divided into several steps:

First, you need to provide collateral (margin) through a broker or exchange to gain permission to borrow assets. Then, you borrow a certain amount of assets, such as 1 BTC, and immediately sell it on the market. At this point, you have opened a short position and need to pay borrowing fees (interest).

Assuming the current trading price of BTC is $100,000, you borrow and sell 1 coin. If the market drops to $95,000 as you expected, you can buy back 1 BTC and return it to the lender, earning a profit of $5,000 (after deducting fees and interest). But if the price unexpectedly rises to $105,000, buying it back will result in a loss of $5,000, plus various fees.

The same logic applies to stocks. Suppose the current price of XYZ Company's stock is $50 per share; you borrow 100 shares and sell them for $5,000. If the stock price drops to $40, you can buy back 100 shares for only $4,000, resulting in a profit of $1,000 after deducting costs. Conversely, if the stock price rises to $60, buying back would cost $6,000, leading to a loss of $1,000 plus additional borrowing fees.

Funding Requirements to Participate in Airdrop Trading

Due to the involvement of borrowed funds, exchanges or brokers will have specific requirements for accounts:

Initial Margin: This is the minimum amount of funds you must deposit. In the traditional stock market, the initial margin is typically 50% of the value of the short position. In the crypto market, it depends on the platform rules and leverage multiples. For example, with 5x leverage, a $1,000 position only requires a $200 margin.

Maintenance Margin: The account must maintain a minimum available balance to cover potential losses. This is usually calculated based on the percentage of account equity relative to total liabilities.

Forced Liquidation Risk: When the margin is insufficient, the exchange will issue a margin call, requesting you to add funds or close part of your positions. If you do not respond in a timely manner, the platform will automatically force liquidate your positions to cover the borrowing, which often results in significant losses.

Two Forms of Short Selling

Collateralized Shorting (Standard Practice): You short sell after borrowing real assets. This is the standard operating procedure and complies with market rules.

Unsecured shorting: Selling an asset short directly without borrowing it first. This is a high-risk and often illegal practice, as it can lead to the phenomenon of “phantom stocks” and market manipulation. Most strict market regulations prohibit this behavior.

The advantages of short selling cannot be ignored

Stable Returns in a Bear Market: When the entire market is declining, traditional long strategies incur losses, but short strategies allow traders to continue profiting.

Hedge Protection: Balance existing long positions by shorting to protect the portfolio during market volatility.

Market Price Discovery: Some analysts believe that short positions can help identify bubble assets and overvalued companies, thereby promoting market pricing efficiency.

Enhance Liquidity: Short selling increases the number of market participants, improving trading activity and execution efficiency.

The Hidden Traps and Risks of Short Selling

Unlimited Loss Potential: This is the biggest risk of shorting. When going long, the maximum loss is limited to the principal, but when shorting, losses are theoretically unlimited—if the asset price keeps rising, your losses will continue to grow. Historically, professional traders have gone bankrupt due to being unable to bear the losses.

Short Squeeze: When many traders hold short positions simultaneously, a sudden price increase can trigger a squeeze effect. Everyone rushes to cover their positions by buying, driving up prices and exacerbating losses. The 2021 GameStop incident is a typical case – retail investors collectively bought shares, pushing up the stock price and forcing a large number of shorts to cover at very high costs.

Borrowing costs continue to rise: The borrowing costs (interest and fees) for scarce assets can be high, especially for high-demand stocks. These costs can gradually erode profits.

Dividends and Distributions: In the stock market, short position holders must pay all dividends issued by the stock during the holding period, which is an additional cost burden.

Regulatory Restrictions: During the financial crisis, many countries imposed temporary bans or strict limitations on short selling, forcing liquidations, which led traders to exit at unfavorable prices.

Market and Ethical Friction

The controversy surrounding shorting has a long history. Opponents argue that short selling exacerbates market downturns, harming companies and employees. During the 2008 financial crisis, aggressive short selling was widely blamed for worsening the market, leading several countries to temporarily ban such trading.

Supporters argue that short-selling mechanisms enhance market transparency, help expose overvalued assets and fraudulent companies, and improve the accuracy of market pricing.

Regulatory authorities are trying to find a balance between two viewpoints. They require the disclosure of large short position information and use tools such as the “Uptick rule”—which restricts short selling during sharp market declines. The SEC's SHO regulation specifically targets manipulative behaviors such as naked short selling.

Summary: Shorting is a double-edged sword

Shorting is an important component of modern financial markets, providing traders and investors with tools to profit or hedge risks during downward trends. Whether in traditional stock markets or cryptocurrency markets, short selling is quite common.

However, it is undeniable that shorting comes with significant risks—potential losses that are theoretically unlimited, sudden short squeezes, accumulating trading costs, and regulatory uncertainties. Successful short traders need to have a deep understanding of these risks and establish strict risk management plans, rather than blindly chasing profits.