What Does Shorting Mean in Crypto and How Does It Work?

Short selling is a financial strategy where investors aim to profit from an asset’s price decline. This contrasts with traditional investing, which expects value to increase. By anticipating a downward movement, participants can gain financially even in a market downturn. This article explores the principles of shorting and their application within the cryptocurrency market.

Understanding the Core Principle of Shorting

Short selling involves borrowing an asset, selling it at its current market price, and then buying it back later at a lower price. The objective is to return the borrowed asset to its lender, profiting from the difference between the initial selling price and the lower repurchase price. This strategy relies on the expectation that the asset’s value will decrease.

For example, if an asset is $100 and expected to fall, an investor borrows and sells it for $100. If the price drops to $70, they buy it back for $70. Returning the asset to the lender yields a $30 profit, before accounting for fees. This process allows market participants to capitalize on negative price movements.

Methods for Shorting Cryptocurrencies

Shorting cryptocurrencies can be accomplished through several distinct methods, each designed to capitalize on an anticipated price decline. These approaches allow participants to take a bearish stance on digital assets without owning them outright. Understanding these methods is important for anyone considering short positions.

One common method involves borrowing cryptocurrencies from an exchange or decentralized lending platform. The user immediately sells the acquired cryptocurrency on the spot market. The expectation is that the price will fall, allowing them to buy back the same amount at a lower price later. This repurchased crypto is then returned to the lender, and the difference constitutes the profit, minus any borrowing fees.

Another method uses futures contracts, particularly perpetual futures, which allow speculation on a cryptocurrency’s future price without direct ownership. To short, a user opens a “short” contract, betting its price will decrease. If the price falls, the short position’s value increases, enabling them to close the contract for profit. Unlike traditional futures, perpetual futures have no expiration date, making them popular for continuous speculation.

Beyond futures, options contracts can also be used for shorting, though they are often more complex. For instance, purchasing a “put” option grants the holder the right to sell a cryptocurrency at a predetermined price on or before a specific date. If the cryptocurrency’s market price falls below the strike price, the option holder can exercise their right to sell at the higher strike price, profiting from the decline. These instruments provide additional avenues for bearish strategies.

Underlying Mechanics and Key Terms

Executing short positions in the cryptocurrency market involves several mechanical components and specific terminology. These elements ensure the stability of lending and trading platforms while managing inherent risks. A clear understanding of these terms is essential for navigating shorting strategies effectively.

Collateral

Collateral refers to assets a borrower pledges as security for a borrowed cryptocurrency or a leveraged trading position. This security protects the lender or exchange against potential losses if the borrower fails to repay the loan or if the position moves unfavorably. The amount and type of collateral required typically ranges from 105% to 150% of the borrowed amount, ensuring sufficient coverage for price fluctuations.

Margin

Margin is the initial capital required to open and maintain a leveraged short position, especially in futures trading. It represents a fraction of the total value, allowing traders to control a larger amount of cryptocurrency with a smaller upfront investment. Exchanges set specific margin requirements, often expressed as a percentage, which must be maintained to keep the position open.

Liquidation

Liquidation is the automatic closure of a short position by an exchange when collateral or margin falls below a predetermined threshold. This prevents the borrower’s losses from exceeding pledged collateral and protects the lender from unrecoverable debt. When liquidated, the platform typically sells the collateralized assets to cover outstanding losses, often incurring a fee ranging from 0.5% to 5% of the position’s value.

Funding rates

Funding rates are periodic payments exchanged between long and short position holders in perpetual futures markets, designed to keep the contract price aligned with the underlying spot price. If positive, long holders pay shorts, indicating a premium. If negative, short holders pay longs, suggesting a discount. These rates typically adjust every eight hours and influence profitability.

Borrowing fees or interest

Borrowing fees or interest are charges applied by lenders for using their cryptocurrency when shorting in the spot market. These fees compensate the lender for the risk and opportunity cost of lending assets. Interest rates vary based on market demand and platform policies, often ranging from 1% to over 20% APR for highly demanded assets, and are usually accrued hourly or daily.