When compared to traditional financial markets, the crypto market is considerably more volatile. A sudden downturn may result in significant price falls in a short span of time.
Cryptocurrencies are speculative assets, and regardless of this volatility, there is plenty of room for long-term traders to earn profits, even in a bearish market.
One of the best ways to make a profit when the market goes down is through short-selling crypto, popularly known as ‘shorting’ cryptocurrencies.
What is Short-Selling or Shorting Cryptocurrencies?
Short-selling is a method in which traders sell cryptocurrencies at a higher price with an intention to buy them back at a later date when their prices fall, thereby making a profit from the price difference.
To understand ‘shorting,’ we must first familiarize ourselves with the long position and short position. In a long position, the buyers buy the currencies at lower prices and expect to make a profit by selling them when the prices are high. In a short position, the buyers purchase the crypto coins and sell them at the current market price. Then when prices fall, the traders will buy them back at a lower price, repay the borrowed capital, and make a profit from the price difference between the selling price and the buying price.
Let’s take an example:
- John wants to short 10 Bitcoin. Now, if the price of each Bitcoin is $50,000, then he will be shorting $5,000,000 (10x$50,000).
- As the price of Bitcoins falls, say, for example, to $40,000 per Bitcoin, then he will buy them back at the current market price, i.e., (10x$40,000) or $4,000,000.
- John now has the same amount of Bitcoin for a significantly less amount. John pays back his broker and make a profit of $1,00,000 ($5,000,000-$4,00,000).
Shorting, though it may seem profitable, is a risky business. The market value of the coins may not move as anticipated. If the prices do not go down and keep on rising for an indefinite period, there is a potential risk of incurring huge losses, and the traders will be forced to buy the cryptocurrencies at a higher price to pay back any loans.
That said, shorting can be a profitable business if the traders do some research and understand the market prices and their movements properly. It is also important to be prepared and calculate unforeseen risks.
Why go for short-selling cryptocurrencies?
- Overvaluation of assets – Sometimes, cryptocurrencies are overvalued at a given point in time. The best way to understand the price metrics is to calculate the intrinsic value of the asset and wait for some time till the price of the coins starts to fall. As the market price falls, the traders can leap into the opportunity and buy the coins back at a much lower price.
- Leveraging through smaller investments – Shorting allows traders to make profits through margin trading. Traders can short a percentage of their funds and make profits through price volatility.
- Hedging long positions – Short-selling helps traders to cover up the losses for holding assets in long positions. It can minimize losses in a bearish market. It is also an important tactic to double profits not only when the prices of the assets rise, but also when the asset price decreases.
Risks of Short Selling
There will always be some risks in crypto trading, and short-selling is no exception.
- The stakes are much higher – When a trader holds an asset in a long position, he can hold onto it for an indefinite period until the prices go up. Short-selling is just the opposite of a long position. If the prices keep on rising, the trader will have no option but to buy at a much higher price in order to pay any loans. So, there is a huge risk of incurring heavy losses.
- Borrower fees – In short selling, traders borrow assets from the borrower. They have to pay interest or fees on the funds they borrow depending on the amount of time they hold the funds. If they hold on to the assets for a long period, the interests will get piling up, and in the end, this may impact the overall profits.
What are the factors to consider for short-selling?
Short-selling has its own risk, so before venturing into this trade, it is important to consider certain factors.
- Study the market – Gather real-time data about the crypto you want to invest in. Track the performance history, trading volume, demand or supply of the coins, price changes, etc. Technical analysis indicators like RSI (relative strength index), ADX (average directional index), and the transaction value or count of the asset help to analyze the movement and trend of the coin.
- Fundamental analysis – This analysis includes the factors that influence the demand and supply of cryptocurrencies, transaction activity, market sentiments, latest updates or news related to the crypto asset, and regulatory status of the coin. It can help traders evaluate whether an asset is overvalued or undervalued.
- Anticipated risks & volatility – While shorting, it’s important to determine the uncapped losses associated with the particular asset. If the market is extremely volatile, there is a high chance of making profits as well as incurring losses. In such cases, it is best to withdraw from the market for the time being.
How to short cryptocurrencies
The crypto market is vulnerable and can be influenced by politics, the latest hypes, trends, and government regulations. Based on these factors, let’s take a look at the different methods of shorting.
Margin trading usually involves borrowing funds from a broker to execute the shorting. The broker lends a percentage of the funds from the exchange for a limited period of time. The trader has to return the borrowed fund within the time period. The longer he holds the funds, the greater the amount of interest. Margin trading also increases the risks of losses because if the trader is unable to procure the amount borrowed within the time period, then he has to buy them at a greater price to pay his debt.
In futures trading, traders buy security against a contract that specifies the time and the price at which the contract is to be sold. While buying securities, traders bet that the prices will go up thereby getting a higher ROI. Similarly, while selling futures, it is expected that the prices will go down.
CFD (contract for differences)
In this method, traders short-sell cryptocurrencies without actually owning them based on the price difference between the opening and closing positions. Traders deposit a margin amount in the exchange to the broker as collateral at a fixed price in anticipation that they will be able to pay off the debt. However, if the crypto prices do not move in the same direction, there are chances of incurring heavy losses.
The put option allows traders to buy cryptocurrencies at a predetermined price at a fixed date, though the investor can sell the assets at any time they want. So, if the price declines, traders can short-sell and make profits. But if the price remains high, they can limit their losses by only paying the put option fees.
Here, investors open the prediction market and bet that the price of the asset will drop by a certain percentage. There is no need to borrow funds. If anyone takes the bet and the prices decline according to the prediction, then there will be a profit.
Shorting cryptocurrency is a good option for experienced traders to make profits in a bearish market. However, for a beginner, it is important to consider the various factors and assess the risks involved in the process. Look out for indicators and keep up-to-date with the latest market news. It is best to trade in small margins to minimize risks.