What is short selling?
Shorting is a trading practice that involves selling a borrowed asset with the hope of repurchasing it at a lower price. Traders who use this strategy often buy their borrowed assets from a broker. While short selling is common in the stock market, it's also possible to short other tradable assets like cryptocurrencies.
A short seller will only profit if their chosen asset falls in value. Also, since short sellers have to return their borrowed shares later, they’ll have to pay interest to their broker until they fulfill their obligation.
Most brokerage platforms that offer short selling require traders to have a minimum amount of capital in their accounts. This minimum is known as the "maintenance margin," and traders need to ensure this balance never goes below their trading platform's requirements.
How does shorting work?
Suppose a trader believes the price of Tesla's stock (TSLA) will drop after an upcoming earnings report. Here, they may consider shorting TSLA shares on their brokerage platform.
Alternatively, imagine TSLA shares are trading for $220 when a short seller opens their position. To initiate a short position, the trader has to borrow TSLA shares from their brokerage platform and immediately sell them.
Continuing with our example, the short seller "shorted" 10 TSLA shares, which equals $2,200 in their balance.
The short seller will pay interest on this TSLA loan until they repay the 10 TSLA shares to their broker. Short sellers also have to ensure the maintenance margin in their account remains above their trading platform's minimum requirement.
In a favorable scenario, TSLA shares would drop after earnings, and the short seller could buy back the 10 shares at a lower price. For instance, if TSLA’s price drops $200 per share, a short seller could buy the 10 shares they owe for $2,000. Excluding trading fees and interest payments, this would give the short seller a profit of $200.
However, if the trader anticipates incorrectly and TSLA shares skyrocket after earnings, the short seller may consider closing their position at a loss to avoid further pain. For instance, a short seller might buy TSLA shares at $240 each to realize a loss of $200 ($2,400 - $2,200 = $200).
Can you short Bitcoin?
Although short selling is closely associated with the stock market, it's possible to short crypto like Bitcoin.
You can also short dozens of digital assets on most centralized crypto exchanges (CEXs) like Kraken, but many short traders buy and sell Bitcoin or Ethereum (ETH). Not only are Bitcoin and Ethereum well-established in the crypto industry, but they also have the best liquidity. It's easier for short sellers to find BTC buyers and sellers versus speculative small-cap projects.
How to short Bitcoin
Shorting Bitcoin follows the same strategy as shorting stocks. Here’s how a trader shorts Bitcoin:
- First things first: A short seller will examine a range of trading platforms and crypto exchanges to short.
- They’ll then assess the overall crypto market’s dynamics to predict the profit or loss situation.
- If they deem the shorting profitable, they’ll start their trade by borrowing BTC from their broker and immediately selling it on the open market.
- As they wait for BTC's price to fall, the short seller must make interest payments and keep their minimum margin requirements in their exchange balance.
- For example, they could borrow 1 BTC at $20,000 and sell it for cash. If Bitcoin's price falls to $15,000, they could buy 1 BTC and return it to the broker to realize a $5,000 gain. However, if BTC keeps climbing to $30,000, they may decide to cut their losses and buy Bitcoin for a $10,000 loss.
Why would traders short Bitcoin?
The two most common reasons traders short assets are to protect a long position or as a short-term speculative trade.
In the first instance, a long-term Bitcoin holder may feel BTC's price is becoming overheated. Rather than sell their BTC for a profit, the investor may open a short position as a "hedge" against their current Bitcoin holdings. This way, even if Bitcoin's price declines, a BTC investor won't lose as much money during a bear market.
However, you don't need Bitcoin in your portfolio to take a short position in BTC. Plenty of crypto traders short BTC whenever they feel the price is too high. Some traders may expect Bitcoin to drop due to a recent news event or technical analysis on price charts. Whatever the case, these speculative traders simply bet BTC will fall in value within a predetermined time frame.
Risks of shorting Bitcoin
Shorting is one of the riskiest trading practices, especially in the volatile crypto market. While you can profit if you correctly predict a crypto downturn, shorting exposes you to theoretically unlimited losses. Here are some risks of short-selling assets:
- Potentially unlimited losses: The lowest an asset can drop is $0. Conversely, there's no limit to how high an asset's price can rise. Therefore, when traders short a stock or crypto, they can theoretically lose an infinite amount of money.
- Crypto volatility: Cryptocurrencies are among the most volatile assets in financial markets. Although projects like Bitcoin and Ethereum have grown in recent years, they tend to rise and fall faster than traditional investments like stocks and ETFs (exchange-traded assets). Traders who are wrong when short-selling crypto are likely to sustain steeper losses in Bitcoin or Ethereum than in blue-chip stocks.
- Interest payments and margin requirements: Short sellers need to make regular interest payments and maintain their brokerage account's minimum margin requirement. Even if a short seller is successful, these costs will cut into their profits.
- Short squeezes: If a stock or crypto unexpectedly rises in value and has a large short interest, it can fall prey to a "short squeeze." In this scenario, traders who were shorting an asset "panic buy" at higher prices to cut off their losses. As more shorts buy the stock or crypto to cover their positions, the asset's price rises due to the increased demand. A prime example of a short squeeze is the rise of GameStop's stock (GME) in 2021.
Other ways to short Bitcoin
Traditionally, Bitcoin short sellers need to borrow BTC from their brokerage, sell it on the open market, and buy back BTC to repay their loan. However, there are other ways traders can bet on a downturn in BTC's price without using this standard short-selling method.
- Bitcoin futures contracts: Many CEXs and derivatives exchanges allow clients to purchase futures contracts that track the price of Bitcoin. Unlike directly shorting BTC, futures contracts require them to sell a specific amount of BTC to contract holders at a particular date. To short BTC futures, sell a futures contract at a higher price to a willing buyer and hope that BTC's price falls at or before the expiration date.
- Inverse BTC ETFs: Short Bitcoin ETFs are relatively new, but they’re available to investors who prefer to trade on the stock market. For instance, investors could take a short BTC position by buying the BetaPro Inverse Bitcoin ETF (BITI). You can buy and sell BITI shares as you would stocks of individual companies.
- Prediction markets: There are a few crypto platforms that allow traders to bet on the price direction of digital coins like BTC. Many of these crypto-betting platforms are dApps (decentralized applications) on the Ethereum blockchain. For instance, Ethereum dApps like Augur, Gnosis, and Omen.eth offer crypto-betting services.
- Bitcoin contract for differences (CFDs): CFDs are similar to futures but don't need any BTC purchasing to close a contract. Although a Bitcoin CFD will track Bitcoin's price, you only need cash to open and close these positions. To short BTC with a CFD, simply buy a contract that has a lower price and monitor BTC's price till the expiration date.
Wrapping up
Although short selling has been around for decades, it's always a risky trading practice. Shorting cryptos like Bitcoin is especially dangerous due to the volatile nature of digital assets. If you’re thinking about shorting a cryptocurrency, carefully review the risks of your strategy before putting a plan into action.
At Worldcoin, we aim to make everyone feel safe when trading cryptocurrencies. To provide each of our clients a head start, we’re giving away a share of our crypto for free. We’re also airdropping free DAI tokens to anyone who downloads our app. Subscribe to our YouTube channel to learn more about the cryptocurrency market.
