How Does Shorting Crypto Work? The Mechanics

Shorting in the cryptocurrency market allows investors to profit from an asset’s price decline. This strategy involves selling an asset at a higher price and buying it back later at a lower price, capturing the difference as profit. It enables potential gains even during market downturns.

Understanding Short Selling

A fundamental method for short selling cryptocurrency involves borrowing, selling, buying back, and returning the asset. A trader borrows cryptocurrency from a platform or lender, often via a margin account. The borrowed crypto is immediately sold on the open market at its current price, converted into stablecoins or fiat currency, with the goal that its price will decrease.

Once the price falls, the trader buys the same amount of cryptocurrency back at the lower price. This crypto is then returned to the original lender, fulfilling the borrowing agreement. Profit is the difference between the initial selling price and the lower buy-back price, after accounting for any associated fees.

To short sell, participants must provide collateral, which acts as security for the borrowed assets. This collateral, often a percentage of the borrowed amount, protects the lender if the market moves unfavorably. Many platforms require an initial deposit as collateral, held in a margin account.

Margin accounts enable traders to borrow funds or assets, increasing their trading position. Borrowing fees or interest apply for using the borrowed cryptocurrency. These fees vary widely based on the asset, platform, and market demand, and are deducted from any potential profit.

A margin call occurs if collateral in a trader’s margin account falls below the platform’s maintenance margin threshold. This happens when the shorted asset’s price increases, reducing account equity. The trader must deposit additional funds to meet the required margin level, or face liquidation.

Liquidation is the automatic closing of a trading position by the exchange or platform when collateral is insufficient to cover potential losses. This occurs if the shorted asset’s price rises significantly and a margin call is not met. While protecting the lender, liquidation can result in the trader losing their entire collateral.

Shorting with Derivatives

Beyond directly borrowing and selling, derivatives allow traders to take a short position in cryptocurrency. These financial instruments derive their value from an underlying asset, enabling speculation on its price movements without direct ownership.

Futures Contracts

Futures contracts are agreements to buy or sell an asset at a predetermined price on a future date. To short crypto, a trader sells a futures contract, obligating them to deliver the underlying cryptocurrency at the agreed price upon expiry. If the spot price falls below the contract’s selling price by the settlement date, the trader buys the asset at the lower market price and delivers it, profiting from the difference.

Many crypto futures contracts are cash-settled, meaning no physical delivery occurs. Profit or loss is the cash difference between the contract’s price and the market price at settlement. This allows traders to bet on future price declines without needing to borrow the actual asset.

Perpetual Swaps

Perpetual swaps are similar to futures contracts but lack an expiry date, allowing traders to hold positions indefinitely. When shorting with perpetual swaps, a trader opens a short position, aiming to profit if the underlying asset’s price decreases.

A funding rate helps keep the perpetual swap’s price aligned with the underlying spot price. This rate is exchanged periodically between long and short position holders. If the funding rate is negative, short position holders receive payments from long position holders, which incentivizes shorting. These payments are determined by the difference between the swap price and the index price.

Options (Puts)

Options are financial contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price (the strike price) on or before a certain date (the expiry date). To short crypto, a trader purchases a “put option,” which grants the right to sell a specific amount of cryptocurrency at the predetermined strike price.

If the market price of the underlying cryptocurrency falls below the strike price before the expiry date, the put option becomes profitable. Profit is derived from the difference between the strike price and the lower market price, minus the premium paid for the option. The premium is the upfront cost of purchasing the option.