What Is Short Selling in Crypto?
Short selling in crypto happens when traders borrow a cryptocurrency and sell it at current market price with the expectation that prices will fall. They will then repurchase the crypto to pay back the loan when the price decreases, earning a profit from the difference between the selling and buying price.
Key Takeaways
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Traders short crypto to increase their exposure to an investment, or to hedge against risk from holding a long position.
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To short crypto, traders have to deposit collateral, which is held by the broker to ensure traders can repay the borrowed assets when closing their position.
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Shorting cryptocurrencies can be risky, as a drastic price increase can lead to the liquidation of short positions.
If you are new to investing and trading, you'd know you can make profits when the prices of assets you have invested in are trending upwards. This traditional way of buying low and selling high has been the cornerstone of financial markets for centuries.
As such, when prices start trending down, most investors cash out of the market due to fear. The crypto fear and greed index illustrates this clearly – fear is highest during a bear market, while greed takes over during a bull market.
What if there was a way to churn profits even when prices are plummeting? Enter short selling (a.k.a. shorting).
Understanding Short Selling
Short selling, commonly known as “shorting,” is a trading methodology that uses leverage (usually borrowed assets like cryptocurrencies) to allow investors to make profits when prices are falling.
In essence, the person shorting an asset is betting that prices will go down and is looking to make a profit from the difference in price when they sell.
The concept of "betting against the market" was popularized by stock traders and has since expanded to several other markets, including crypto.
Short selling is an advanced trading tactic and entails more risk than the conventional method of buying low and selling high. However, if done right, it will yield outsized returns compared to methods that do not involve leverage.
How Does Short Selling Work?
In short selling, there are three entities involved:
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Trader/Investor (Borrower): the person who is shorting the asset
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Broker (Lender): the party that provides the asset to be sold
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Buyer: the person who buys the asset from the trader on the exchange
The Trader first borrows an asset from the Broker at the current market price and promises to return the asset at a later date.
The Trader then sells this asset to the Buyer immediately.
When the time comes to return the asset to the Broker, the Trader repurchases it (a.k.a. covering the short) on the exchange and returns it to the broker.
If the price has gone down from when the Trader first borrowed the asset to when they returned it, the Trader would make a profit by pocketing the difference.
If the price had risen from when they first borrowed it to when they returned it, the Trader would have to bear the losses from the additional cost.
Understanding Short Selling with an Example
Let's understand shorting with the example of the WETH/USD pair.
Source: Link to chart
The above chart from GeckoTerminal shows the price of WETH against USD. Let's take the example of a trade on 6 May 2023 (denoted by the white vertical line).
Say the Trader borrows 100 WETH from the Broker at a price of $1991.99 each (denoted by the green horizontal line) and sells it to a Buyer in the market at the same price. Now, the Trader has a liquidity of $199,199.
When the price falls to $1895.32 (denoted by the yellow horizontal line), the Trader buys 100 WETH from the market again using the liquidity earned initially and returns to the Broker. This amounts to $189,532.
The difference between $199,199 and $189,532 is the profit that the trader pockets. This amounts to $9,667.
What Is a Short Position?
In trading lingo, taking a short position simply means selling an asset that you do not currently own.
The Trader in the above example has taken a short position in WETH. This short position was established when the Trader borrowed 100 WETH from the Broker and sold it to a Buyer.
Why Short Crypto?
Short-selling crypto takes the conventional concept of "buy low, sell high" and flips it: "sell high, buy low."
We've already established shorting crypto involves borrowing cryptocurrencies from a Broker and selling them. That's how you can sell assets that you do not already own.
Investors short crypto for two main reasons:
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To increase their exposure to an investment
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To hedge against risk from a long position
Increase Exposure to an Investment
Shorting crypto by taking leverage increases your exposure to an investment.
There are different levels of leverage you can use to increase your exposure. 2x, 3x, 5x and 10x leverages are common.
What this means is that if you use 2x leverage, your profits will double for every percentage increase in the asset's price. Similarly, for every percentage decrease, your losses also double.
Let's take our example of the WETH/USD pair.
Source: Link to chart
Say you want to short 100 WETH at 10x leverage, and you open a short position at the price of $1991.99.
This would imply that you only need $19,919.9 to make a trade worth $199,199 – a 10x increase in exposure. When the price plummets to $1895.32, and you repay your debt, you are left with a profit of $9,667 – a 48.5% profit on your initial investment for 4.85% decrease in the asset's price.
Hedge Against Risk
While shorting involves high risk, it can also be used to mitigate risks. This trading strategy, where you reduce your overall risk by opening a counter trade, is called “hedging”.
Let's understand this with an example chart shown below.
Source: Link to chart
In the chart, WETH price increased from $1301.13 on 21 October 2022 to $1646.46 on 4 November 2022. It then fell to $1100.45 on 9 November 2022.
Now, say you had bought 100 WETH worth $130,113 on 21 October 2022 but were worried about the decrease in its price. In such a case, you could have opened a short position on 4 November 2022 (when the price was $1,646.46). This would have enabled you to capitalize on any potential losses from your long position when the price went down.
Essentially, you would have reduced your risk by taking a counter trade and made some profits on the decreased price.
But what if the price did not fall?
Well, you would still benefit from the increase in the WETH price because of your long position. This is how shorting can be used to hedge against risk – by taking a low-risk counter trade that offsets potential losses from your main investment.
Note that if you do not close your short position soon enough when the price rises instead of falling, then you might suffer a net loss.
Say that the short position resulted in a net loss of more than what was borrowed. How will the Trader repurchase the asset from the market to return to the Broker?
Enter margins.
Understanding Margins: Collateral for Leverage
When taking a loan from a traditional bank, you are usually required to deposit some collateral to cover the loan.
Similarly, when you take leverage (also a type of loan), you are required to deposit some amount as collateral. This is usually about 50% of the borrowed amount.
In the case of shorting, margins are essentially a security deposit that you need to provide in order to borrow assets from your Broker.
At times, the margin becomes insufficient to cover the potential losses. In such cases, you will receive a margin call, which means you need to provide additional collateral or close your position.
This additional margin is called a "maintenance margin" and is usually about 30% of the borrowed amount.
If you do not provide the maintenance margin, your position will be liquidated, and you are responsible for any losses incurred.
How to Short Crypto?
Shorting crypto successfully requires a significant understanding of trading strategies and risk management. It is important to learn the fundamentals thoroughly and implement sound trading practices.
There are different ways to short crypto, like using margin accounts, futures, options, and CFDs.
Below is a step-by-step guide to short crypto through margin trading.
Step 1: Set up a Margin Account
Most of the popular and large cryptocurrency exchanges, like Binance and KuCoin, allow you to set up a margin account.
Step 2: Choose Leverage
Determine the amount you want to leverage and decide on a suitable leverage. The higher the leverage, the greater the risk. So, if you are just getting started, you can try with smaller amounts.
Step 3: Deposit Margin
Next, deposit assets into your margin account to act as collateral. These assets belong to you but are held by the broker to ensure you can buy back the borrowed assets when closing your position.
Step 4: Borrow Cryptocurrency
You can borrow the cryptocurrency you want to short from the Broker. How much you can borrow depends on your margin and the borrowing limits of the specific cryptocurrency.
Typically, cryptocurrencies with high liquidity have higher borrowing limits.
Here, you should enter the price at which you want to borrow (this will be the current price of the asset) and how many coins or tokens you want to borrow at the price.
Say the current price of 1 WETH is $2,000, and you want to borrow 10 WETH. You will enter "$2,000" in the price field and "10" in the amount field.
Now, you have $20,000 worth of WETH in your account.
Step 5: Trade Cryptocurrency
Trade the borrowed WETH on the market by selling it immediately and buying it back at a later date at a lower price.
Step 6: Repay Cryptocurrency
Once you complete the trade, repay the cryptocurrency to the broker by entering the current price and the number of coins or tokens you borrowed.
Say, you bought back the assets when the current price is at $1,000 per WETH. Enter $1,000 in the price field and enter 10 in the amount field. You have now repaid all your debt (of 10 WETH now worth $10,000) and pocketed the difference as profit, i.e., $10,000.
For simplicity of calculations, we have assumed there is no interest on the borrowed amount.
Is Shorting Crypto Safe?
Short selling entails a large amount of risk because the asset's value can theoretically climb to infinity. Simply put, you can lose an infinite amount of money.
Short selling is highly speculative in nature. Educate yourself on different trading strategies, and indicators, staying updated on the latest industry news, and studying the fundamentals of the asset you are shorting will help you minimize guesswork in your trades.
Yet do note that cryptocurrency markets are highly volatile, and investors should exercise caution when making risky trades.
Beware of a Short Squeeze
A short squeeze is a phenomenon where there is a sudden and highly unexpected interest in a cryptocurrency that quickly drives its price up. The sudden rise in price leads to even more investors buying the asset and further drives the price up, resulting in the liquidation of short positions as they cannot keep up with the margin calls.
This sudden increase in price can be due to several factors, including rapid positive news about the asset or even market manipulation by whales.
Source: Link to chart
The chart above shows the sudden rise of WETH's price against USD from $1859.74 to $2,108.62 (a 13.38% increase) in 48 hours.
This liquidation also contributes to an increase in price because the assets are being repurchased to repay the debt.
When to Short Crypto?
There is no surefire way to identify when to short crypto for the best returns. However, here are a few considerations to help you identify when the markets are right for shorting.
Bear Markets
Bear markets are when cryptocurrency prices are mostly declining. This presents several opportunities to open a profitable short position.
Bearish Patterns
Look for patterns like bearish flags and bearish divergences as they indicate a market reversal and could be indicative of when to enter a short position.
Overbought
When an asset has been trading at an abnormally high price for a sustained period, it is likely overbought, and most investors are sitting on profits. Hence, they might begin to sell and lower the price. If this happens, it could be a good opportunity to short the asset.
Conclusion
Short selling cryptocurrencies can help you earn highly skewed returns compared to the initial investment, but ensure that you are mindful of all the risks involved before shorting cryptocurrencies.
An important point to note is that shorting an asset is usually used for short-term trades. This is because Brokers usually charge interest on the borrowed assets, which accrues over time. Therefore, the longer you put off repaying the debt, the more interest you are liable to pay.
Frequently Asked Questions
Can crypto be shorted?
Yes, cryptocurrencies can be shorted on several exchanges, including Binance, KuCoin, Bybit, and OKX.
What are short sellers?
Short sellers are investors who bet on the price of an asset to plummet.
What is short sell order?
A short sell order is an order that speculates on the decrease in the price of an asset.
Is short selling legal?
Short selling is legal in some parts of the world and illegal in others. It also varies from asset to asset. Investors should do their due diligence to ensure they are compliant with all local regulations.
Is short selling ethical?
Short selling is just another financial vehicle. Whether short selling is ethical or not depends on the trader’s intent and due diligence. It is essential to ensure you are engaging in legal activities when short selling.
How to short crypto on Binance US?
You cannot short crypto on Binance US. However, other international Binance entities allow you to short cryptocurrencies through margin trading, futures, and more.
How to short crypto on Coinbase Pro?
You can short crypto on Coinbase Pro using derivatives. Short selling crypto on Coinbase Pro is not possible through margin trading.
How to short crypto on Gate.io?
You can short crypto on Gate.io through margin trading.
How to short crypto on Crypto.com?
You can short crypto on Crypto.com through margin trading.
Sankrit is a content writer and a subject matter expert in web3. He has worked with notable companies, including Ledger, Alchemy, and MoonPay. Sankrit specializes in helping web3 brands create content that is easy to understand while accurately explaining technical concepts.
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