Can I Short Crypto? Methods, Mechanics, and Taxes

Shorting in financial markets allows investors to profit from an asset’s price decline by selling it at a higher price and buying it back lower. While commonly associated with traditional securities, this strategy has extended to the cryptocurrency market, offering ways to gain from downward price movements. Understanding its methods and mechanics is essential.

Common Avenues for Shorting Crypto

One prevalent approach is spot margin trading, where users borrow a specific cryptocurrency from an exchange and immediately sell it on the open market at its current price. The expectation is that the price will fall, enabling the user to repurchase the same amount of cryptocurrency at a lower cost to repay the borrowed amount, thereby profiting from the difference. Platforms typically require an initial deposit, known as collateral, to facilitate these borrowed funds.

Another common method involves cryptocurrency futures contracts, which are agreements to buy or sell a cryptocurrency at a predetermined price on a future date. To short using futures, an individual would sell a futures contract, betting that the asset’s price will decline before the contract expires. Perpetual futures contracts, a popular variation, function similarly to traditional futures but lack an expiration date, allowing positions to remain open indefinitely. These contracts are designed to track the underlying asset’s spot price, with mechanisms like funding rates ensuring alignment.

Options trading provides another avenue for shorting, primarily through the purchase of put options. A put option grants the holder the right, but not the obligation, to sell a specified amount of cryptocurrency at a predetermined “strike” price on or before a particular date. If the cryptocurrency’s market price falls below the strike price, the option holder can exercise their right, sell at the higher strike price, and profit from the difference.

Finally, inverse exchange-traded products (ETPs) offer a more simplified way to gain inverse exposure to cryptocurrency prices without directly engaging in complex derivatives or borrowing. These products are designed to move inversely to the price of a specific cryptocurrency, meaning their value increases when the underlying asset’s price decreases. Investors can purchase shares of these ETPs through traditional brokerage accounts, similar to buying stocks or traditional ETFs.

Operational Aspects of Shorting Crypto

When shorting through margin trading or derivatives, borrowing digital assets is often a prerequisite. Platforms require traders to provide collateral, typically in stablecoins or other cryptocurrencies, to secure the borrowed funds and mitigate risk for the lender. This collateral serves as a security deposit, and its value must be maintained above certain thresholds to keep the short position open.

The concept of margin is central to leveraged shorting, encompassing initial margin and maintenance margin. Initial margin is the minimum amount of capital required to open a leveraged position. Maintenance margin, on the other hand, is the minimum equity a trader must maintain in their account to keep the position active. If the market moves unfavorably and the value of the collateral falls below the maintenance margin level, the trader may face a margin call, requesting additional funds to restore the margin balance.

For perpetual futures contracts, funding rates help keep the contract’s price aligned with the underlying spot market price. Funding rates are periodic payments exchanged between long and short position holders. When the funding rate is positive, long positions pay short positions. Conversely, a negative funding rate means short positions pay long positions.

A key risk in leveraged shorting is a liquidation event, which occurs when a trader’s margin account no longer holds sufficient funds to support their open position. If a margin call is not met or if the market moves rapidly against the short position, the exchange will automatically close the position. This forced closure aims to prevent further losses, but it can result in the loss of a significant portion or even all of the initial collateral.

Tax Treatment of Crypto Shorting

The tax treatment of cryptocurrency shorting for individuals generally aligns with the principles applied to traditional financial assets, though specific nuances exist due to crypto’s classification as property by the Internal Revenue Service (IRS). Gains and losses from short positions are typically realized for tax purposes only when the short position is closed, meaning the borrowed cryptocurrency is repurchased and returned to the lender. These realized gains or losses are usually treated as capital gains or losses.

The holding period for a short sale determines whether any realized capital gains or losses are considered short-term or long-term. If the short position is held for one year or less, any gains or losses are generally classified as short-term capital gains or losses and are taxed at ordinary income tax rates. If the short position is held for more than one year, any gains or losses are typically considered long-term capital gains or losses, subject to more favorable tax rates.

While the wash sale rule is a significant consideration in traditional securities trading, current IRS guidance does not explicitly apply it to cryptocurrency. Because cryptocurrency is classified as property rather than a security, the wash sale rule has not explicitly applied, allowing taxpayers to claim losses from selling crypto and immediately buying it back.

Taxpayers involved in crypto shorting activities must accurately report their transactions to the IRS. Gains and losses from these activities are typically reported on Form 8949, Sales and Other Dispositions of Capital Assets, and then summarized on Schedule D, Capital Gains and Losses.