When valuing investments, one typically assumes that one will benefit from rising asset prices and suffer losses if prices fall. However, a more sophisticated approach is short selling, or “short selling,” which involves speculating against an asset by anticipating its future price decline.
Short selling is often associated with the stock market, but the practice extends to cryptocurrencies as well. Many digital assets exhibit high volatility, resulting in significant gains or losses over a short period of time. The prospect of huge profits tempts many investors to sell cryptocurrencies.
This article examines cryptocurrency short selling and comprehensively decodes its nature and mechanics. You can also visit Cryptocurrency Help to learn more about crypto investing.
What is cryptocurrency shorting?
Shorting cryptocurrencies is selling cryptocurrencies at a higher price to later buy them back at a lower price, usually when the cryptocurrency is expected to decrease in value. The term “short selling” comes from being “short” on the cryptocurrency, meaning you don’t actually own it.
To understand this concept, you need to know what long and short cryptocurrency positions are. Going long means buying cryptocurrencies with the belief that their value will increase. For example, you buy Ethereum for $800 and sell it for $1,000 at a profit of $200.
Conversely, short selling means borrowing and selling a cryptocurrency at the current price with the expectation of a loss in value. You later buy it back when the price goes down, making a profit on the difference between your original selling and buying price.
Short selling makes it possible to profit from the depreciation of an asset. Traders might short a cryptocurrency if they predict its value will go down. However, due to the unpredictability of the market, it is risky.
How to short cryptocurrencies?
Now that you are familiar with shorting cryptocurrencies, let’s dive into the different approaches to shorting cryptocurrencies.
Direct short sale
When looking into short selling cryptocurrencies, the first method many people learn is to borrow cryptocurrencies from an exchange at a certain price and then sell them. This is called a direct short sale.
After this step, expect a price drop. Once such a drop occurs, buy back the cryptocurrency and return the borrowed amount to the exchange. This practice allows you to make a profit equal to the difference between the two prices.
futures markets
Similar to various other assets, certain cryptocurrencies also participate in futures markets, where you commit to buying a crypto token through a contractual agreement. This contract specifies the agreed sale price of the token and the time frame for this transaction.
If you choose a futures contract, you need to bet on the price increase of the token. This decision allows you to earn future profits from the price increase of that particular token. Conversely, selling the futures contract means that you anticipate an impending price drop, especially during a bearish market.
contracts for difference
Contracts for difference (CFDs) are a standard way of short selling cryptocurrencies. CFDs allow speculating on price changes without owning the actual asset. Brokers make this easier by requiring a margin deposit, a fraction of the trade’s value, as collateral. This deposit guarantees you the opportunity to buy the cryptocurrency at the predicted price.
The structure offers the potential for higher ROI if your prediction is right. Still, the risks are significant; If the price deviates from your forecast, the fraction of safety can result in a position liquidation, especially when prices rise significantly.
Prediction Markets
If you want to understand how you can participate in short selling cryptocurrencies in a community of other investors, prediction markets offer an opportunity worth exploring. These markets function in a similar way to traditional mainstream markets.
In this system, you, as an investor, can predict the decline of a specific cryptocurrency by a certain percentage or margin. Another person must then accept your prediction.
If the price actually moves in the predicted direction, you can make a profit. Notable prediction market platforms include Augur and Polymarket.
Cryptocurrency put options
Cryptocurrency put options offer a risk-free way to sell cryptos. In a bear market, you can use this complex derivatives technique. Buying put options allows you to go short without jeopardizing your investments.
A put option grants the buyer the right to sell a cryptocurrency at a specified price on a specified date. Importantly, this is a right, not an obligation, that gives users the ability to exercise the option.
For example, if you expect bitcoin to go down, you can buy a 3-month bitcoin priced at $20,000. If bitcoin falls below this price on the specified date, your put will generate a trading profit. If prices stay high, all you lose is the option premium, the fee for holding the option.
Risks Associated with Cryptocurrency Short Selling
Shorting cryptocurrencies offers profits during market downturns, but also carries potential risks. These risks include:
Unlimited losses
Shorting cryptocurrencies exposes you to the possibility of unlimited losses that exceed your initial investment. If the price of the cryptocurrency goes up, you may need to borrow it at an even higher rate to lower your average cost. Should the trade eventually fail, you will incur a significant loss.
margin rate
If the market fluctuates, you can keep the borrowed coins for a longer period of time. During this period of stagnation or growth, accrued interest accumulates and eats away at some of your potential profits. If the cryptocurrency price continues to rise and you decide to cut your losses, you will not only miss out on the price rise, but you will also bear the burden of significant costs (in the form of interest) of short selling.
Exchanges that support cryptocurrency shorting
Cryptocurrency shorting can be done through numerous exchanges or platforms and offers different methods depending on your preferences. For example, well-known exchanges like Kraken, Binance, Bitfinex, Bybit, BitMEX, and Coinbase allow users to purchase futures contracts.
In addition, established brokerage firms such as TD Ameritrade also provide access to such options.
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