Can You Short Crypto? Methods, Platforms, and Risks

Short selling cryptocurrencies is a viable strategy for those who anticipate an asset’s price decline, allowing individuals to profit from downward market movements. Understanding the various methods and mechanics for shorting crypto is essential for engaging in this market activity.

Core Principles of Short Selling Crypto

Short selling cryptocurrency involves borrowing an asset. The process begins with borrowing a specific cryptocurrency, such as Bitcoin or Ethereum, then immediately selling it on the open market at its current price. The objective is to repurchase the same amount of cryptocurrency at a lower price in the future. If the price falls as predicted, the trader buys it back for less than it was initially sold for. The difference between the higher selling price and the lower repurchase price, minus any associated fees or interest, constitutes the profit.

Platforms and Tools for Shorting Crypto

Various methods and financial instruments enable the short selling of cryptocurrencies without owning the underlying asset directly.

Margin Trading

Margin trading involves borrowing cryptocurrency from an exchange or broker to sell it immediately. A trader deposits a portion of the trade’s value as collateral and borrows the remainder. If the price of the borrowed asset falls, the trader buys it back at the lower price to repay the loan, profiting from the difference. This method amplifies potential gains and losses, as the position size is larger than the initial capital.

Futures Contracts

Futures contracts are agreements to buy or sell a specific cryptocurrency at a predetermined price on a future date. To short crypto using futures, a trader sells a contract, locking in a future sale price. If the cryptocurrency’s spot price falls below the contract’s agreed-upon price by the expiration date, the seller buys the asset at the lower market price and delivers it for the higher contract price, realizing a profit. Futures allow speculation on price movements without direct ownership of the asset.

Options Contracts

Options contracts provide the holder with the right, but not the obligation, to buy or sell an asset at a specific price before a certain date. For short selling, put options are used. A put option gives the buyer the right to sell a cryptocurrency at a set strike price. If the market price of the cryptocurrency falls below the strike price, the holder can exercise the option, selling the asset at the higher strike price and profiting from the difference.

Perpetual Swaps

Perpetual swaps are a type of futures contract without an expiry date. They mimic the price of the underlying cryptocurrency. When shorting with perpetual swaps, a trader takes a sell position, benefiting if the asset’s price declines. A unique feature is the funding rate, a periodic payment exchanged between long and short positions to keep the contract price aligned with the spot price.

Inverse Exchange-Traded Products (ETPs)

Inverse Exchange-Traded Products (ETPs) are financial instruments designed to move in the opposite direction of a specific cryptocurrency’s price. These products allow investors to short an asset without needing to borrow or directly sell the underlying cryptocurrency. If the price of the cryptocurrency decreases, the value of the inverse ETP increases. Inverse ETPs are traded on traditional stock exchanges.

Decentralized Finance (DeFi) Protocols

Decentralized Finance (DeFi) protocols offer avenues for short selling crypto through lending and borrowing platforms. Users can borrow cryptocurrencies directly from a pool of lenders, often by providing other assets as collateral. Once borrowed, the crypto can be sold on the open market. The expectation is to buy back the crypto at a lower price to repay the loan, with smart contracts automating the process.

Managing Short Positions

Holding a short position in cryptocurrency involves several operational aspects and mechanisms.

Collateral Requirements

Collateral is a necessary component of most short selling methods. When initiating a short position, traders must deposit a certain amount of their own funds or other cryptocurrencies as collateral with the exchange or lending platform. This collateral acts as a safeguard for the lender, ensuring borrowed assets can be recovered if the market moves unfavorably. The amount of collateral required is a percentage of the total value of the short position.

Liquidation

Liquidation is an automatic process that closes a short position when the market moves significantly against the trader’s bet, and collateral falls below a certain threshold. If the price of the shorted cryptocurrency rises too much, the collateral’s value may become insufficient to cover the potential loss. The exchange or platform will automatically sell the collateral to cover the borrowed amount. This mechanism protects the lending system but can result in the complete loss of a trader’s collateral.

Leverage

Leverage allows traders to control a larger position with a smaller amount of initial capital, amplifying both potential gains and losses. When shorting with leverage, a trader borrows funds to increase their exposure to the price movement of the shorted asset. For example, 5x leverage means controlling a position five times larger than the deposited capital. While leverage can magnify profits, it also significantly increases the risk of liquidation, as smaller adverse price movements can lead to a rapid depletion of collateral.

Funding Rates (for Perpetual Swaps)

For perpetual swaps, funding rates are periodic payments exchanged between long and short position holders. These rates ensure the perpetual swap’s price remains closely aligned with the underlying spot price. If the perpetual swap price is higher than the spot price, long position holders pay short position holders. Conversely, if the perpetual swap price is lower than the spot price, short position holders pay long position holders. Funding rates are calculated every few hours and can fluctuate based on market demand.

Borrowing Fees/Interest

Engaging in short selling often involves recurring costs in the form of borrowing fees or interest. When cryptocurrencies are borrowed, the lender or platform charges a fee. These fees can vary depending on the asset, the platform, and market demand. These costs accumulate over the duration the short position is open and reduce the overall profitability of the trade.

Tax Implications

In the United States, cryptocurrencies are treated as property for tax purposes. When a short sale position is closed, any gains realized are subject to capital gains tax. If the position was held for one year or less, the profit is considered a short-term capital gain and is taxed at ordinary income tax rates, which can range from 10% to 37% depending on the taxpayer’s income bracket. For positions held longer than one year, any profit is classified as a long-term capital gain, taxed at lower rates of 0%, 15%, or 20%.