The phrase “shorting Bitcoin” gets used a lot by traders, and just from the context, it is easy to discern that it means betting that the BTC market will go down. What is less obvious is how traders can make money off of a drop in an asset’s value, and where does the average person get involved? That’s why BeInCrypto has made a handy guide to what shorting really is and how it applies to cryptocurrency.
In This Article:
- How Does Shorting Crypto Work?
- Popular Ways to Short Crypto
- Margin Trading
- Prediction Markets
- Where Can I Short Cryptocurrency?
- Conclusions – Should You Short Crypto?
How Does Shorting Crypto Work?
The basic logic behind shorting is that you want to make a financial gain off of a drop in the value of an asset. While this seems counter-intuitive, there are actually several different ways to do this, and we’ll cover the most common here. Often the term shorting refers to a form of margin trading, but investors can also use futures and prediction markets to reach the same goal. Let’s go over each of these now.
Popular Ways to Short Crypto
1. Margin Trading
Margin trading refers to the practice of borrowing money from an exchange in order to set your position. Often this is used to trade at leverage, but it can also apply to shorting an asset. How it works is that an exchange will basically let you borrow some commodity with an agreement to return it at a later time. While you are in possession of the asset, you are free to do with it as you please, so long as it is returned by the agreed-upon time.
How this can make a trader money is simple:
- Let’s say Jim thinks Bitcoin is going to drop soon.
- He can borrow 5 (or whatever amount) BTC from the exchange and sell them, with the agreement to give back 5 BTC in a month.
- Assuming Jim is correct, then he buys 5 BTC sometime later in the month for less than he sold them for, returns them to the exchange, and pockets the difference.
While this is great if Jim is correct, it can get pretty troublesome if he is wrong.
See, with regular trading where an asset is simply bought when the price is low and sold when the price is high, and assuming no leverage is used, then the most risk an investor ever takes is the amount of money they put in. For example, if you buy Bitcoin and it drops 50% you can just wait until it comes back up before selling, as you can just keep holding the asset. Losses are only realized when they are locked in. However when you short you have to agree on a time limit to return the asset. So if you short Bitcoin and it goes up 50%, you now have to buy back the BTC loaned to you at a higher price, causing you to lose funds, and you have to give it back to the exchange. This means you not only lost a bunch of money, you don’t even have the Bitcoin to show for it.
This entire scenario can become even more dangerous when someone shorts an asset using leverage. As mentioned, leverage is similar in that it also involves the exchange loaning an investor extra cash in order to make a larger position than they would have otherwise been able to afford, hence letting them receive 5x, 10x even 100x or more than they would have otherwise. Of course, these multipliers work against the trader as well, meaning losses can also become massive, fast. This is effectively how you sometimes hear of traders getting “rekt” even by a positive swing in Bitcoin’s price.
Another popular way to short an asset is to deal in futures contracts. Essentially, futures are agreements to buy or sell an asset at a fixed price and on an agreed-upon date. In many ways, this can work just like margin trading, but the details are a little different. In this case, say again that Jim thinks BTC will go down. He can then enter into a futures contract that agrees that Jim will sell his Bitcoin in one month, but at today’s price. If Jim is correct and Bitcoin tanks, he still sells at the price that the contract outlined. Of course, again if Jim is wrong he could miss out on potentially far greater returns.
Now, Jim doesn’t have to create this contract directly. Futures can be traded much like the underlying assets they represent. Their value will be based upon the details of the contract, current market conditions, and the time remaining before expiration. Therefore if Jim is predicting a bad time for Bitcoin, he can purchase a contract that delivers BTC at current prices, and even before the contract ends he could flip it to another investor, locking in his profit at virtually any time. In this way futures, investors can earn from the value of these contracts without being obligated to fulfil them, so long as they aren’t holding them when they expire.
One thing that is a benefit for futures is that it protects from the intense risk that can come with margin trading. The following example is a bit on the extreme side but highlights the difference. If Jim made a margin trade and Bitcoin went parabolic to the upside, say 200% growth when Jim had anticipated a drop, then he is still responsible for paying back that BTC no matter how high the price goes. This can be financially ruinous in some cases. However if Jim had used a futures contract he would definitely miss out on massive gains, but would still be selling his Bitcoin at the agreed-upon price. He doesn’t really profit, but he will still have something to show for it at the end.
3. Prediction Markets
A prediction market is basically a fancy term for gambling on the outcome of events. Users take “long” or “short” positions on various events like political elections or movements in financial markets. It could be almost anything, but of course, betting on the price movements of cryptocurrency is a common practice, and there exist multiple markets already running on blockchains like Ethereum’s. In this way you can short Bitcoin (or any asset) by literally just placing a bet in the price drop. While these markets can indeed be risky, they can also provide important insight into what the public honestly thinks about future events, as users have little incentive to bet for anything they don’t really believe in with a high degree of confidence. In this way, predictions markets are often highly accurate at forecasting the outcomes of certain events, which adds to their value.
One downside currently with cryptocurrency-powered predictions markets is that they are still somewhat small. This can mean that there can be a limited amount of pools being run at any time, and starting a new pool doesn’t guarantee takers. Major events are usually covered, and betting on major assets like Bitcoin are also often available, but users should know that small-cap coins may not be getting bet on nearly as much, meaning this may not be the best shorting option for all investors.
On the positive side, and much like with futures, this type of shorting also limits exposure to the basically infinite risk that margin trading poses. While the wager may not go your way, there should be a clearly defined agreement for what that will cost you. This also opens up a variety of options for betting on how much Bitcoin may fall, and on longer timescales. For example, one could make the prediction that Bitcoin will not reach a new all-time high by the end of this year. All that has to happen is for Bitcoin to fail to pass that mark, as opposed to needing very specific levels to be hit. Obviously the payout isn’t as generous for broader predictions, but it gives speculators more flexibility in the bets they place.
Where Can I Short Cryptocurrency?
Pros of Bitfinex:
- One of the most popular sites for trading on margin.
- Offer up to 5x leveraged trading.
Cons of Bitfinex:
- Do not offer leveraged trading to customers from the US or a few other areas where such practices are strictly regulated.
Pros of Poloniex:
- Offer up to 5x leveraged trading.
Cons of Poloniex:
- Also do not offer leveraged trading to customers from the US.
Pros of Binance
- Binance exchange offers up to 125x leverage in some markets.
- One of the biggest exchanges in the world.
Cons of Binance
- Unfortunately, Binance also doesn’t allow US customers.
Pros of Kraken
- This is where Americans can go to get their shorting game on.
- A highly popular exchange.
Cons of Kraken
- Only allows for 5x leverage.
- While these exchanges are great for beginners and do allow US customers, they are unfortunately not ideal for shorting, at least for beginners. While Coinbase Pro, (or GDAX), is rolling out margin trading accounts, it is doing so slowly and only offering them to high-rolling clients. Beginners are unlikely to be able to deposit enough funds on the exchange to be eligible at this time.
- As for Robinhood, there are no direct ways to short through the service. There are certain options and techniques that can be used in a similar fashion to shorting, but they are out of the scope of this article and not recommended for beginners.
Things to consider when choosing an exchange to short Crypto:
On any of these sites, users should know that they will be required to go through various levels of Know-Your-Customer verification in order to be approved for a margin account. Furthermore, it should be expected that you will need to fund your account with collateral before you can trade with a multiplier or short an asset. The amount needed can vary by exchange and how big of a position you are looking to take. Often you will need at least 1/5 to 1/3 of your desired trade value. For example, say you want to trade $3000 worth of BTC, you will probably need to have at least $1000 worth in your margin wallet before the exchange will lend you funds.
Where Can I Trade Futures?
Here again, there are a variety of options. Bitfinex and Binance still are some of the top offerings, and Kraken continues to be the best choice for US customers. Users should be aware that in many places cryptocurrency futures trading is still unregulated, meaning that local laws could change without much notice and this is an inherent risk in the practice, at least for now.
To avoid these concerns, customers can turn to some options available from the institutional world. CME Group and Bakkt both offer products for Bitcoin futures, though admittedly the minimum deposit needed to open a trading account with one of these firms may be a bit higher than many retail investors are prepared for. Still, these venues are much safer as they come from government approved and regulated companies, meaning there shouldn’t be any surprises coming down the line in terms of regulations.
Where Can I Bet On Predictions Markets?
- Lastly, there are a few notable predictions markets you can get involved with today. Augur is one of the most popular and well known, but there are many other options available such as Predictious and GNOSIS. As mentioned these markets are generally somewhat small and still experimental, but can offer a great alternative for those uncomfortable with some of the complexities that come with margin trading and futures.
- Be aware that much like some of these other topics, local regulations around predictions markets may vary wildly. Since these are generally run on a blockchain and powered by smart contracts, they could remain difficult to oversee, but this is another area of cryptocurrency where the final word is not yet written.
Conclusion – Should You Short Crypto?
While shorting an asset can be risky, the same is true of all investing. Shorting can be a powerful tool to hedge against surprise downturns and generally add diversity to a portfolio. In the right hands it can generate huge returns at a time when many investors are panic selling, but this also opens traders up to fairly intense dangers. As a general rule users should start small, or better yet begin on a demo account. Many exchanges offer “dummy” trading accounts with fake assets so that newcomers can get their feet wet and learn, with no actual risk involved. This can be a great way to decide if shorting is a strategy you might be interested in.
It certainly isn’t for everyone, but with the help of this guide you should be ready to go explore one or more of these shorting options. Even if you decide you aren’t interested, understanding it can make the entire cryptocurrency market, and in fact, the global economy, make a little more sense.