The Basics Of Shorting Bitcoin
Bitcoin has had a bad year so far. But traders who knew how to successfully short bitcoin and other cryptos on the way down have done rather well. In this article, we’ll explore the concept of shorting crypto further.
Disclaimer: shorting is risky—especially with volatile assets. Personally, I would only ‘go short’ if I have a strong conviction that the price will go down. As always none of this is investment advice, it’s for information and education only.
A quick explanation of shorting
Traders are opportunists. If they see an opportunity for the price of an asset to go up, they take a long position (buy). But if their analysis suggests the price will go down, they take a short position (“sell short”). This allows them to potentially profit in falling markets.
The below example explains the basic mechanics of a short sale…
Example: Bob wants to short bitcoin
Bitcoin is currently priced at $6500. Bob’s technical analysis suggests the price will go down to $6000. Therefore, Bob decides to take a short position on Bitcoin.
The steps below show how Bob does this…
First Bob must “open” a short position. To do this, he:
- Borrows 1 bitcoin on an exchange.
- Instantly sells the 1 bitcoin he borrowed at the current market price of $6500.
When the price is later at $6,000, Bob wants to “close” his short position so he can bank profits. To do this, he:
- Buys back 1 bitcoin for $6,000 on the exchange.
- Instantly returns the 1 bitcoin to the exchange.
Since Bob borrowed 1 bitcoin for $6,500 (higher price) and returned it to the exchange at $6,000 (lower price), his profit is $500.
Side note: Bob would usually have to pay ‘interest’ on the bitcoin he borrowed. This would reduce his profits. We’ll cover this point in the next section!
The below diagram sums up the basics steps of a short trade:
Collateral and loan interest
As explained in the above example, to short an asset you need to borrow it. To borrow you need money or assets in your trading account that serve as collateral. This is also called margin.
Collateral assures the lender that you can pay back the loan (i.e. borrowed bitcoin). This is just like when you apply for a mortgage with the bank. The bank will only lend you money if it knows you are rich enough to cover the loan.
So in the case of Bob, he may need to have assets in his trading account worth, say, $2,000, to serve as collateral for the exchange to let him take a short position.
Collateral is the first requirement to borrow. The second is being able to pay interest. The longer you ‘stay in the trade’ the more interest you will need to pay. Therefore, it’s best not to be in a short position for too long!
Going back to Bob, his $500 profit from the trade would be reduced by the interest he paid on the borrowed bitcoin (this fee could be $50 for example).
Margin calls and short selling
As mentioned above, margin is the collateral in your trading account needed to trade with borrowed money or assets (i.e. leverage). When you first enter the trade, this margin is known as your initial margin requirement.
Let’s say Bob’s initial margin requirement for his 1 bitcoin short position is half a bitcoin. If Bob entered the short sale when the price was $6,500, and the price went up instead of down, Bob needs more collateral to cover his potential losses.
At some point, Bob’s potential losses will be high enough for him to get margin called!
This means the exchange is ‘calling for Bob to increase his margin’—Bob must, therefore, put down more of his own money to stay in the trade. If he can’t afford to post the extra margin, he is forced to exit his trade at a loss.
To prevent a margin call, Bob can set a Stop Loss at a price point that protects his risk.
Side note: personally I would NEVER enter into a short position (or any leveraged trading position) without setting a Stop Loss. Read the above-linked article after this for more. If you short an asset without a Stop Loss, your potential losses could be massive as the price can go up much higher than you ever expect.
How to short bitcoin and other cryptos
With effective risk management, you can potentially earn good profits over time by shorting bitcoin and other cryptos. This is because cryptos are extremely volatile, which creates a lot of opportunity for short sellers.
There are several crypto exchanges which allow you to short bitcoin and other cryptos such as Kraken, Bitmex, Binance, Bitfinex, GDAX and many others.
Each of these exchanges has their own nuances for short selling. It is worth getting fully up to speed with these before considering a short trade on any one of these exchanges.
I’ll start with Kraken for my next post on this topic.
Another way to short bitcoin is through the bitcoin futures market.
Jonathan Hobbs, CFA, is an author, entrepreneur and financial blogger. He is the Chief Investment Officer of the quantitative digital asset hedge fund, Block X Wealth (Pty) Ltd. In his personal portfolio, he invests in stocks, mutual funds, startup companies, gold and digital assets.