Short selling (sometimes called going short or just shorting) is something traders do when they want to profit when the price of an asset drops. In crypto, shorting can be extremely exciting and profitable, but it can also be a risky strategy if not done right. By the end of this article, you will know what short selling is, how it works and the best ways to do it.
What is short selling?
Shorting is the opposite of going long (when you buy an asset expecting its price to go up). Therefore, you should short when you expect a currency to decrease in value, and go long when you expect it to increase in value.
On most exchanges, to open a short position you have to borrow some cryptocurrency and then sell it at the current price. Then, you have to buy that same digital currency back at a later date and repay the capital you borrowed. If the price of that coin drops by the time you buy it back, you will make a profit on the difference between the cost of buying and selling.
Here is an example:
- You want to short one Bitcoin when the market value of Bitcoin is $50,000. So you borrow one Bitcoin and sell it at market value, earning $50,000.
- The price of one Bitcoin then drops to $35,000.
- You buy one Bitcoin for $35,000 and return it to the broker you borrowed it from plus interest.
- You keep the difference between the sale and purchase price, meaning $50,000 – $35,000 = $15,000 (minus any interest).
This example illustrates very clearly how shorting usually works, but it’s just as important to know that there are several reasons to short sell crypto.
Reasons for Short Selling Crypto
Valuation
You may think a particular cryptocurrency is in a price bubble or overvalued. If you pick up on this kind of trend, it’s probably a good time to short sell that crypto for profit. This is where a fundamental trading style and analysing the intrinsic value of a coin against its current market price might help you know when you can buy back the borrowed crypto coins.
Volatility
The high volatility of crypto markets might be a problem for you if you are somewhat risk-averse. However, traders use that volatility to make money and, as I have mentioned here before, they short sell crypto to profit even when a market’s price falls and use volatility to their advantage.
Hedging Risk
Another interesting way to use shorting is to reduce your risks when trading. Maybe that sounds strange to you because you have heard short selling is risky, so how could you use it to reduce risk? Well, you can. Imagine you believe an altcoin will outperform the entire crypto market but you are not sure if the whole market will crash during that time. One way to hedge against that risk would be to open a position going short on Bitcoin. That way, if the price of Bitcoin goes down, you can reduce your losses or even still make a profit if the market price falls.
The Risks Of Shorting Crypto
Potential for Unlimited Losses
A huge problem with short selling is its potential for unlimited losses. When you buy a cryptocurrency (go long), you can never lose more than what you initially invested. Since there is no limit to how high the price of any crypto can go, your potential gain is, at least in theory, infinite.
However, if you short crypto at $50, the most you can make on that transaction is $50 (if you are not trading on margin). But here is the catch: if that crypto goes up to $100, you’ll have to pay $100 to close your position. The same is true if the price goes up to $1000. In other words, there's no limit on how much money you could lose on a short sale.
Margin Interest: Borrowing Crypto to Sell
Trading on margin allows you to leverage the funds in your account to borrow more funds and increase your buying power. In other words, it means you borrow money to trade with more than what you have.
When you trade on margin, you increase the odds of having a higher reward by taking on extra risk. Because you are borrowing money, you owe it back along with any applicable fees, no matter what. To make sure they receive the loaned amount back, exchanges will usually liquidate your margin trade once it hits a price where you would start losing the borrowed funds. But depending on which exchange you are using, if your trade goes south you may end up actually losing the owed funds and then some.
Short Squeezes
As a short seller, you borrow crypto that you believe will drop in price and sell it now, in order to buy them after they fall. If you are right, you return the crypto and pocket the difference in price between when you initiated the short and when you close the position. But if you are wrong and the price goes up, you are forced to buy that asset back at a higher price, leading to loss.
If the price of an asset you shorted rises fast, you need to act quickly and close the position to limit your losses. Now imagine a lot of people are shorting a market at the same time as you. And as you decide to buy the asset back to cut their losses, so do they. As a result, the price is pushed even higher, attracting even more buyers that push the price further up. A short squeeze is a combination of new buyers and panicked short sellers that creates a rapid rise in price that can lead short sellers to have massive losses.
How to Short Crypto
Before you use any method to short sell crypto, you have to identify a downtrend. Since the market is highly volatile, many factors can send it in one direction or another. For example, politics, hype culture and even tweets from influencers can disrupt the crypto market.
Make sure you study the news and sentiment around any currency you plan to short. After that, you have to open your margin trading account. Most crypto brokers allow you to short sell. However, you also have to check your country’s regulations to ensure you’re not violating any laws or regulations.
Now that you know more about short selling crypto, let’s cover the five different ways you can short it.
Direct Short Selling
This is the first method you will usually come across when researching short selling. Simply put, direct short selling is when you borrow crypto from an exchange at a specific price and sell it.
Then you wait for the price of that crypto to go down. When it does, you buy it back and return the borrowed coins to your exchange. This way you profit from the difference in prices.
Futures Markets
Like many other assets, some cryptocurrencies have futures markets. Those are markets in which you agree to buy a security in a contract that specifies the price at which the security will be sold and the time when this will happen.
Futures come with a long and a short side of the contract. While one party agrees to deliver at a future date, the other agrees to accept the delivery. The long contract benefits if the price of the market goes up, and the short side benefits if the price goes down. There is always an equal number of long and short contracts in the markets (that number is called open interest).
Contracts for Difference
This is one of the most popular ways of shorting crypto. With contracts for difference, your broker allows you to bet on the change in an asset’s price without having to actually own it. You can bet on the price going up or down.
All you have to do is deposit a part of the margin account’s fund to guarantee that you’ll be able to buy the crypto at the particular price you’re betting on. While the deposit stays in your possession, the exchange or broker gets to hold it as collateral.
As a result, you only need to give away a small part of the total trade amount to open your position. This amplifies your return if the market moves in the direction you expect, but it also amplifies your losses if the market goes against you. This method is extremely risky if your prediction is wrong.
Crypto Put Options
This is a way to short crypto while reducing your investment risks. A put option gives you the right to sell a cryptocurrency at a predefined price on a set date in the future. But it’s not an obligation.
Imagine you think that Bitcoin’s price will drop next year. With put options you can buy a Bitcoin put for six months with a strike price of $40,000. If the price of Bitcoin falls below that price on the predetermined date your put will earn you a profit, because you can sell Bitcoin at $40,000 instead of at its lower market price. However, if the price remains high, the option expires worthless, and all you lose whatever you paid for purchasing that option.
Prediction Markets
Prediction markets are similar to mainstream conventional markets. As an investor, you may expect the price of a cryptocurrency to decrease by a particular percentage. On a prediction market, someone else can take you up on that bet. If the price really does go the way you predicted, you earn a profit. Popular prediction markets include Polymarket and Augur.
Virtual Futures
Virtual futures are a novel way to short cryptocurrencies. They were introduced by Morpher, a trading app that uses Ethereum to create a set of smart contracts that observe the price of all kinds of exchange-traded assets globally and in real time. The Morpher protocol uses that data to replicate the economics of holding that asset on the blockchain. Via its native token (MPH) bets can be made on any of the markets that the protocol supports, like Bitcoin, Apple, or Gold. Instead of trading by buying from or selling to another person, you interact with a smart contract on Morpher.
That makes shorting extremely easy. Trades happen immediately and there are no commissions. If your position earns a profit, the smart contract mints a proportional amount of tokens. If you realise a loss, the contract destroys a proportional amount of staked tokens. So 100 MPH invested in Bitcoin becomes 110 MPH, if the price of Bitcoin increases 10 percent, or 90, if the price goes down 10 percent.
How to start short selling crypto
As you have seen in this article, short selling can be somewhat complicated. If you are a beginner, virtual futures are by far the easiest and safest way for you to start shorting. Virtual futures allow you to trade with a smart contract as your counterparty, and you don’t need to borrow funds from another party or pay interest to short a market.
To start shorting via virtual futures create a free account on Morpher. Every new account is already funded with 100 MPH tokens, the platform‘s native token, which you can use to short all the cryptocurrencies listed on the app. Morpher also allows you to trade traditional assets, such as stocks, currencies and commodities.
Happy shorting!
