How to Short Crypto Currency: Methods and Tax Implications

Short selling in the cryptocurrency market allows individuals to potentially gain from a decline in an asset’s price. The volatile nature of cryptocurrencies has made short selling a notable strategy. Engaging in this practice requires a clear understanding of its mechanisms and the various methods available.

Understanding Short Selling Cryptocurrency

Short selling involves borrowing an asset, selling it at the current market price, and then buying it back at a lower price to return it to the lender, profiting from the price difference. If the asset’s value falls as anticipated, the short seller repurchases it at a reduced cost, repays the loan, and retains the difference, minus any associated fees.

Collateral, an asset like a stablecoin or another cryptocurrency, is pledged to secure the borrowed asset. It ensures the lender has a safeguard if the borrowed asset’s value moves against the short seller’s position. Collateral requirements depend on the platform and leverage.

Margin refers to funds borrowed from a platform or broker to open a larger trading position than one’s own capital allows. An initial margin requirement specifies the percentage of the trade’s value covered by the trader’s own funds. Borrowed capital amplifies gains and losses, making risk management important.

Monitoring a short position includes being aware of margin calls and potential liquidation. A margin call occurs if collateral value falls below a threshold, prompting a request for additional funds. If the trader fails to meet this, the position may face automatic liquidation, where the exchange forcibly closes the position to cover the loan and prevent further losses. This forced closure can lead to significant losses.

Maintaining a short position involves periodic costs, such as funding rates or borrowing fees. Funding rates are common in perpetual futures markets, where payments are exchanged between long and short position holders to keep the contract price aligned with the underlying spot price. These rates are calculated every few hours; a negative rate means short position holders receive payments, while a positive rate means they pay. Borrowing fees are direct interest charges for the cryptocurrency borrowed in margin trading.

Cryptocurrency borrowing occurs through centralized exchange margin facilities or decentralized lending protocols. These platforms provide the liquidity for traders to borrow assets against their collateral. Borrowing terms, including interest rates and collateral ratios, are determined by the specific platform and market conditions.

Executing Short Positions

Executing a short position in cryptocurrency begins with selecting a reputable platform that supports the desired shorting method. Most major cryptocurrency exchanges offer various tools for short selling, including margin trading and derivatives. Understanding platform features and requirements is important before initiating any trade.

Margin Trading

Margin trading is a common method for shorting cryptocurrencies, where you borrow funds to amplify your trading position. To begin, deposit funds and enable margin trading, which may involve a separate margin wallet. After funding the margin account, select the cryptocurrency you wish to short and enter a “sell” order. This borrows and sells the asset at the current market price.

Managing a margin short position involves monitoring the asset’s price and collateral levels. Platforms display your margin ratio, and if the price moves unfavorably, you might face a margin call, requiring additional collateral to avoid liquidation. Setting stop-loss orders automatically closes your position if the price rises to a predetermined level, limiting losses.

To close the short position, buy back the same amount of cryptocurrency initially sold. If the price has dropped, repurchase the asset at a lower cost. Then repay the borrowed cryptocurrency to the lender; the difference between the initial selling price and the repurchase price, minus fees and interest, constitutes your profit. Buying back and repaying the loan settles the borrowed amount.

Futures Contracts

Futures contracts, particularly perpetual futures, offer another way to short cryptocurrency without directly owning the underlying asset. A futures contract is an agreement to buy or sell an asset at a predetermined price on a future date, or, for perpetual futures, without an expiration date. When shorting with futures, you sell a contract, anticipating the asset’s price will decline.

To open a short position with perpetual futures, choose the contract for the cryptocurrency you expect to fall in value. Then decide on the leverage level, which determines the size of your position relative to your collateral, and place a “sell” order for the futures contract. Leverage magnifies profits and losses, so consider risk carefully.

Managing a perpetual futures short position involves monitoring funding rates, which are periodic payments exchanged between long and short traders to align contract price with spot price. If the funding rate is positive, short position holders receive payments, while a negative rate means they pay. Monitor your liquidation price, as high leverage can lead to rapid liquidation if the market moves against your position.

Closing a futures short position involves placing an equivalent “buy” order for the same contract. This offsets your initial sell position, realizing profit or loss based on the price difference. Perpetual futures contracts often settle automatically based on the closing price.

Options Trading (Put Options)

Options trading provides a more defined risk profile for shorting, particularly through the purchase of put options. A put option grants the holder the right, but not the obligation, to sell an underlying asset at a specified price (the “strike price”) on or before a certain expiration date. By buying a put option, you profit if the cryptocurrency’s price falls below the strike price. The maximum loss for buying a put option is limited to the premium paid.

To initiate a short position with a put option, select the cryptocurrency, choose a strike price that aligns with your bearish outlook, and pick an expiry date. Then purchase the put option, paying a premium. This premium is the cost of acquiring the right to sell the asset at the strike price.

The value of your put option increases as the underlying cryptocurrency’s price declines. Monitor the market to determine the optimal time to either sell the option for a profit or exercise it. If the asset’s price falls below your strike price before expiration, you can sell the option back into the market or exercise your right to sell the cryptocurrency at the higher strike price. Exercising the option means selling the cryptocurrency at the strike price, even if its current market value is lower. Closing the position involves selling the put option before expiration to realize profit, or letting it expire worthless if the price does not fall as anticipated.

Tax Implications of Shorting Cryptocurrency

The Internal Revenue Service (IRS) treats cryptocurrency as property for tax purposes, not currency. Transactions, including short selling, are subject to capital gains or losses. Closing a short position, whether profitably or at a loss, constitutes a taxable event.

Profits from short selling cryptocurrency are considered capital gains. The tax rate applied depends on how long the underlying asset was held, referring to the period between selling the borrowed asset and buying it back to repay the loan. If this period is one year or less, gains are short-term capital gains, taxed at ordinary income tax rates (10% to 37% for individual filers). If the effective holding period for the asset used to close the short position exceeds one year, gains may be long-term capital gains, subject to lower preferential tax rates (0% to 20% for most taxpayers).

Other financial aspects of shorting, such as borrowing fees or funding rates, have tax implications. Borrowing fees paid to platforms for cryptocurrency use may be deductible expenses, reducing the taxable gain from a successful short trade. However, the specific tax treatment of these fees depends on individual circumstances and evolving tax guidance. Similarly, payments received from funding rates in perpetual futures may be considered ordinary income.

Record-keeping is important for all cryptocurrency activities, especially when short selling. Taxpayers are responsible for maintaining accurate records of every transaction, including the crypto asset type, date and time, number of units, and U.S. dollar value at the time of each transaction. This documentation helps calculate gains and losses, substantiate cost basis, and fulfill reporting obligations to the IRS.

Tax laws are subject to change and can vary based on individual circumstances and state regulations. The information provided here is for general informational purposes only and does not constitute tax advice. Consulting a qualified tax professional is recommended to understand your specific tax obligations related to shorting cryptocurrency and ensure compliance.