Can Crypto Be Shorted? A Review of the Methods

Short selling is a financial strategy allowing investors to profit from an asset’s price decline. While traditionally associated with stocks, its principles now apply to cryptocurrencies. This article explores various methods for shorting cryptocurrencies, including margin trading, derivatives, and alternative investment products.

The Concept of Short Selling

Short selling involves borrowing an asset, selling it at the current market price, and then repurchasing it later at a lower price to return to the lender. The objective is to profit from an anticipated decrease in the asset’s value. For example, if an investor believes a stock currently trading at $100 will fall, they might borrow 100 shares and sell them, receiving $10,000. If the stock drops to $80, they can buy back the 100 shares for $8,000, return them to the lender, and profit $2,000 before any fees.

To initiate this position, an investor “borrows” the asset, typically from a broker, and “sells” it on the open market. To close the position, they “buy to cover,” purchasing the same quantity to “return” to the lender. A margin account is generally required, facilitating asset borrowing and holding collateral. Interest is usually charged on borrowed assets for the duration of the short position.

Shorting Cryptocurrencies Using Margin Trading

Shorting cryptocurrencies through margin trading involves borrowing digital assets from an exchange or other users with the expectation that their price will decline. This method allows traders to sell an asset they do not own, aiming to buy it back at a lower price to repay the loan. For instance, a trader anticipating a drop in Ethereum’s price could borrow ETH and sell it at the current market rate. If the price falls as predicted, they can repurchase the ETH at a reduced cost, return the borrowed amount, and realize a profit from the price difference.

To engage in margin trading, a trader must typically open a margin account with a cryptocurrency exchange and deposit collateral. This collateral, often in fiat currency or another cryptocurrency, serves as security for the borrowed funds. The amount of collateral required, known as the margin requirement, varies by exchange and the level of leverage used. Leverage amplifies both potential gains and losses, meaning a small price movement can have a significant impact on the position’s profitability or loss.

A critical aspect of margin trading is the concept of liquidation. If the price of the shorted cryptocurrency rises significantly, moving against the trader’s position, the exchange may issue a margin call, requiring additional collateral. Failure to meet this margin call can lead to automatic liquidation, where the exchange forcibly closes the position to prevent further losses and recover the borrowed funds. This automatic sale of the collateral can result in the loss of the trader’s entire initial investment.

Shorting Cryptocurrencies Using Derivatives

Financial derivatives offer another method for shorting cryptocurrencies. These contracts derive their value from an underlying asset, allowing investors to speculate on price movements without directly owning the cryptocurrency. Derivatives offer varying risk profiles and complexities compared to direct margin trading.

Crypto Futures Contracts

Crypto futures contracts are agreements to buy or sell a specific cryptocurrency at a predetermined price on a future date. To take a short position, a trader sells a futures contract, obligating them to deliver the cryptocurrency at the agreed-upon price at expiration. If the cryptocurrency’s price falls before the settlement date, the trader can buy an equivalent contract at the lower market price, fulfilling their obligation and profiting from the difference. Unlike some spot shorting methods, borrowing the underlying asset is not always necessary with futures, as the contract itself represents the obligation.

Crypto Options

Crypto options, specifically put options, provide another avenue for short exposure. A put option grants the holder the right, but not the obligation, to sell a specific amount of cryptocurrency at a predetermined price (the “strike price”) on or before a certain date. If the cryptocurrency’s price declines below the strike price, the holder can exercise their option, selling the crypto at the higher strike price and profiting from the market difference. Conversely, if the price rises, the option may expire worthless, limiting the loss to the premium paid for the option. Selling a call option is another strategy that can offer short exposure, where the seller receives a premium and profits if the crypto’s price falls, making the option expire worthless.

Perpetual Swaps

Perpetual swaps are a type of futures contract that do not have an expiration date. They are designed to mimic spot market prices through a mechanism called a “funding rate.” The funding rate is a small, periodic payment exchanged between long and short position holders, typically every eight hours. If the perpetual swap’s price is higher than the underlying spot price, long position holders pay short position holders, incentivizing shorting and pushing the contract price back towards the spot price. Conversely, if the perpetual swap trades below the spot price, short position holders pay long position holders. This dynamic funding mechanism allows traders to maintain short positions indefinitely, as long as margin requirements are met and funding fees are managed.

Alternative Approaches to Short Crypto Exposure

Beyond direct borrowing or complex derivatives, investors can gain exposure to a declining cryptocurrency market through alternative investment products. These methods often provide inverse performance without the direct mechanics of short selling or the intricate management of derivative contracts. Such products are typically structured to reflect the opposite movement of a specific cryptocurrency or a basket of digital assets.

Inverse exchange-traded products (ETPs) or exchange-traded funds (ETFs) are designed to provide returns that move inversely to the performance of an underlying cryptocurrency. For example, an inverse Bitcoin ETF aims to increase in value when the price of Bitcoin falls, and decrease when Bitcoin’s price rises. These products often achieve their inverse exposure by utilizing financial derivatives like swaps, futures contracts, or options, rather than directly shorting the underlying asset. Some inverse crypto ETPs may offer leveraged exposure, meaning they aim to return a multiple of the inverse daily performance, such as -1x or -2x.

While similar to traditional ETFs, inverse ETPs are typically structured for short-term trading and may not perfectly track the inverse performance over extended periods due to factors like fees, compounding, and tracking errors. Examples of such products include the ProShares Short Bitcoin ETF (BITI) or the T-REX 2X Inverse Bitcoin Daily Target ETF (BTCZ), which aim for daily inverse performance. These instruments offer a simplified way for investors to bet against cryptocurrencies without directly engaging in borrowing or managing complex derivative positions, making them accessible to a broader audience.