Can You Short Crypto? How the Process Works

Short selling is a financial strategy allowing investors to profit from a decline in an asset’s price by selling an asset they don’t own, then buying it back later at a lower price. The profit is the difference between the selling and repurchase prices. While traditionally associated with stocks, shorting digital assets like cryptocurrencies is now widely available, allowing individuals to take a short position anticipating a downward movement in market value.

Understanding the Core Process of Short Selling

Short selling involves a sequence of transactions designed to capitalize on an asset’s price depreciation. Initially, a short seller borrows an asset, such as a cryptocurrency, from another party, often a brokerage or exchange. This borrowed asset is then immediately sold in the open market at its current price. The short seller now holds cash from the sale but also has an obligation to return the borrowed asset.

The expectation is that the asset’s price will fall during the period the asset is borrowed. If the price does decline, the short seller can then purchase the same amount of the asset back from the market at the new, lower price. This repurchase is known as “covering” the short position. Finally, the newly acquired asset is returned to the original lender, fulfilling the borrowing obligation. The profit is the difference between the higher price at which the asset was initially sold and the lower price at which it was repurchased, minus any fees or costs associated with the borrowing.

Methods for Shorting Crypto

Several methods allow individuals to engage in short selling within the cryptocurrency market, each utilizing distinct financial instruments and platforms. These approaches enable traders to implement the core short-selling process of borrowing, selling, and repurchasing.

Margin Trading

Margin trading is a common way to short cryptocurrencies, facilitated by many centralized exchanges. With margin trading, users open a margin account and can borrow cryptocurrency from the exchange, using their own deposited capital as collateral. For instance, if a trader believes the price of Bitcoin will drop, they can borrow Bitcoin from the exchange, immediately sell it, and then aim to buy it back at a lower price to repay the borrowed amount. The amount of cryptocurrency one can borrow is typically a multiple of their collateral, known as leverage, which amplifies potential gains and losses. Exchanges manage the borrowing process, including interest rates on borrowed funds and collateral requirements to maintain the position.

Futures Contracts

Futures contracts provide another avenue for shorting crypto assets without directly borrowing the underlying asset. A futures contract is an agreement to buy or sell an asset at a predetermined price on a specified future date. To short a cryptocurrency using futures, a trader would “sell” a futures contract, obligating them to deliver the underlying cryptocurrency at the agreed-upon price. If the spot price falls below the contract price by expiration, the trader buys the asset at the lower market price and delivers it, profiting from the difference. Perpetual futures, which have no expiration date, are also popular, allowing traders to maintain short positions indefinitely as long as they meet margin requirements.

Key Terms in Crypto Shorting

Understanding specific terminology is important for anyone considering short positions in the cryptocurrency market. These terms describe the mechanics and risks associated with leveraged trading strategies.

Margin

Margin refers to the capital an investor must deposit with an exchange or broker to open and maintain a leveraged trading position, such as a short sale. It acts as collateral, ensuring that the trader can cover potential losses. For example, an exchange might require a 10% margin, meaning for every $10,000 worth of crypto borrowed and sold short, the trader must have $1,000 in their account as collateral. This initial margin helps mitigate the risk for the lender.

Leverage

Leverage allows traders to control a larger position size with a relatively small amount of their own capital. It is expressed as a ratio, such as 5x or 10x, indicating how many times the value of the trade exceeds the margin deposited. If a trader uses 10x leverage, a $1,000 margin deposit allows them to control a $10,000 position. While leverage can magnify profits from favorable price movements, it also significantly amplifies potential losses if the market moves adversely.

Funding Rates

Funding rates are periodic payments exchanged between long and short positions in perpetual futures contracts. These rates help to keep the price of the perpetual futures contract anchored to the spot price of the underlying cryptocurrency. If the funding rate is positive, long position holders pay short position holders, and if it is negative, short position holders pay long position holders. These rates typically adjust every eight hours, affecting the cost of holding a short position over time.

Liquidation

Liquidation occurs when a leveraged position is automatically closed by an exchange because the collateral, or margin, falls below a predetermined maintenance level due to adverse price movements. If the price of a shorted cryptocurrency rises significantly, eroding the margin, the exchange will forcibly close the position to prevent further losses to the lender. This automatic closing protects the exchange and the liquidity provider from potential defaults. Upon liquidation, the trader’s entire margin for that position is typically lost.