Short selling, put simply, is a way to profit when asset prices decline rather than increase. It involves temporarily borrowing then selling assets you don’t own outright – with the goal of buying them back later at lower prices to return what was borrowed, pocketing the difference.
Applied to the volatile world of cryptocurrency, shorting strategies allow traders to hedge or speculate on falling crypto coin prices. Instead of relying only on “long” positions going up, bears can bet on corrections during bubble-like euphoria.
However, while fiat currencies have some underlying stability, cryptocurrencies are subject to extreme volatility magnifying risks beyond typical short selling. Prices fluctuate rapidly 24/7 across global markets. Heavy leverage use requires intense position monitoring against margin calls.
Still, with proper risk management various instruments make shorting Bitcoin, Ethereum and altcoins accessible even for retail traders with relatively small accounts.
We will explore major avenues including:
- Crypto futures contracts
- Margin trading borrowing
- Options puts
- DeFi lending platforms
Along with execution tips balancing risks and profit potential. By the end, you’ll understand what crypto shorting entails across centralized and decentralized platforms to consider as part of a balanced trading strategy whether speculating or hedging.
Now let’s start with the basics behind short positions generally before diving into cryptocurrency specifics.
Short Selling Basics
While terminology can confuse new traders, short selling simply means temporarily borrowing then selling assets you don’t currently own with the intent to repurchase later at hopefully lower prices. Your profit comes from the price difference between initially selling high then covering the short at a lower price point:
Short Sale Price – Repurchase Price = Profit
For example, if Bitcoin trades at $20,000 currently and you open a short position, you are betting the price will fall below that level. If Bitcoin then drops to $18,000 in the future, you make $2,000 profit buying back the borrowed coins to return at the lower price (20,000 – 18,000 = 2,000 profit).
Of course losses happen conversely if prices increase and you must repurchase higher than originally sold. This amplifies risks which we’ll cover shortly. But first, what motivates short selling fundamentally?
Cryptocurrency Shorting Challenges
While shorting instruments have expanded, cryptocurrencies pose unique challenges exacerbating risks beyond traditional markets. Consider these factors before shorting crypto:
Extreme Volatility
As an emerging asset class, cryptocoins fluctuate wildly in value often multiple percentage points day over day even absent major news. This requires close monitoring against margin liquidations. Newer low market cap coins see even more violent swings speculatively.
Perpetual Markets
Unlike stocks only trading during exchange hours, global crypto markets trade 24/7 perpetually, even weekends and holidays. This allows no downtime unwinding short exposures during off hours should prices spike against positions.
Thin Liquidity
Despite growth, crypto markets remain relatively thin in liquidity compared to mature assets like securities and forex. This contributes to slippage on exits and wicks trapping stops. Plan entries/exits carefully accounting for volatility.
In essence: When shorting crypto, expect high stakes games of risk management. The decentralized arena provides little sympathy to mistakes. Next we’ll cover major instruments facilitating shorts.
Futures Contracts
Crypto futures contracts allow speculating on price movements without owning spot coins. While futures apply both to long and short betting, we’ll focus on the short selling mechanics:
How Futures Shorting Works
Future contracts have a set expiration date where positions close at the Bitcoin or altcoin index price at that time. In between, leveraged exposure tracks performance of the underlying coin price. Short futures bet that price will fall below the futures rate at purchase.
For example, trader Alice buys a short contract on Ethereum at a futures price of $1,500 with 50x leverage. If Ethereum drops to $1,400 near expiration, Alice’s position gains 50 * (1,500 – 1,400) = $5,000 profit due to the leveraged ETH price difference.
Now two common futures contract types include:
Cash Futures
Cash futures have defined expiration dates where contracts close at settlement engaging trading counterparties to exchange the underlying asset at that set price. This requires full capital upfront to take physical delivery if holding through expiration.
Cash futures allow accurate reference benchmark pricing for settlement dates but require managing settlement logistics.
Perpetual Futures
In contrast, perpetual futures contracts have no expiry date, allowing positions held indefinitely. These derivatives simply track relative price changes rather than target fixed settlement values. Funding rates compensate long/short variance from spot indexes to incent balance.
Perpetuals require less upfront capital with more flexibility holding indefinitely without settlement burdens. But increased complexity calculating funding impacts.
Now let’s discuss major platforms offering crypto futures products.
Popular Crypto Futures Exchanges
Leading centralized exchanges like Binance, OKX, Coinflex, Deribit and FTX provide futures trading on Bitcoin, Ethereum and other altcoins with deep liquidity. Before shorting evaluate factors like:
- Market depth filling orders
- Funding rates impacts
- Leverage ratios allowed
- Collateral options beyond crypto like USD
- Fees structures – transaction, rollover, settlement etc
- Regional restrictions blocking access
For example, FTX recently acquired BlockFi extending up to 100x leverage with borrow rates as low as 0.01% accepting fiat or coins collateral in a regulated US entity. Compare options balancing risks, rewards and convenience suiting your situation.
And that provides an intro to shorting through futures across some major platforms to evaluate. Let me know if you need any specifics around features, restrictions etc covered further on centralized exchanges before we get into additional avenues like decentralized lending!
Margin Trading
Margin trading allows shorting select cryptocurrencies by borrowing coins directly from integrated lending pools rather than futures derivatives.
For example, a trader wants to short 100 ETH anticipating price dropping. The margin exchange loans the 100 ETH, which that trader immediately sells at say $1,500 spot price per ETH totaling $150,000 value.
If ETH then drops to $1,400, the trader buys back 100 ETH for $140,000 repaying the borrowed coins, and pockets the $10,000 price difference as profit (excluding fees).
Now let’s explore margin trading dynamics further:
Managing Risks
While granting more direct market exposure beyond futures, margin shorting uniquely risks liquidations if borrowed asset values increase rapidly multiples higher forcing automatic position closures near peak catastrophic losses.
Careful configuration of stop losses matters balancing risk mitigation without premature exits on volatile swings:
Maintenance Ratio
To limit exchange risk lending funds, margin platforms impose minimum equity maintenance ratios like 25%. This means your account balance must retain 25% of the position notional value.
If prices rise violating that threshold due to losses, margin calls lead to liquidations. Monitor distance to margin limits during volatility avoiding sudden undercapitalization.
And with that background understanding margin trading risks, let’s shift gears into the world of options contracts for short positions.
Options Contracts
Beyond futures and direct margin trading, options contracts provide additional instruments to profit from bearish price speculation.
Puts Ideal For Shorts
While call options benefit from upwards breakouts, put options grant the buyer future rights, but not obligations, to sell an asset at a specified “strike” price anytime prior to expiration even if market values decline far lower.
For example, if trader Bob buys a put on Ethereum for a $2,000 strike price lasting 90 days, and ETH declines steeply to $1,500 in those 3 months, Bob could exercise the put option selling his ETH at the locked in $2,000 value per coin for a solid gain against plunging market rates.
In essence, puts insure downside exposure targeting price floors. Ideal for bear cases without margin liquidation risks.
And that provides a primer on utilizing options contracts to speculate on falling crypto prices! Let me know if you would be interested in any specifics around options trading platforms, liquidity concerns, no-arbitrage dynamics etc. or shall we shift gears into emerging world of decentralized finance (DeFi) shorting opportunities?
DeFi Lending Platforms
Beyond centralized parties like exchanges and brokers, decentralized applications built atop blockchain networks now facilitate peer-to-peer short selling direct between counterparties without intermediary risk exposures.
Smart contracts programmatically enforce collateral locks, interest rate calculations, liquidation thresholds and settlement flows. While innovations still actively developing in the DeFi space, early infrastructure unlocks provocative opportunities.
For example, lending protocols like Aave, Compound and MakerDAO allow supplying stablecoins or cryptocurrencies into community pools earning yield interest paid by borrowers. Short sellers can dynamically borrow coins from these pools to immediately sell against future repurchasing lower.
Now let’s break down DeFi lending short mechanics further:
Overcollateralized Borrows
Because no credit checks occur on-chain, borrowers overcollateralize to mitigate risk, similar to pawning an item of higher value when taking loans. This provides security deposits protecting against default non-repayment.
For instance, borrowing $5,000 USD of crypto may require locking $8,000 worth of ETH collateral. If the borrower fails to repay, the protocol liquidates the ETH collateral to make lenders whole.
Health Factors
Unlike margin trading at centralized entities with static rates, decentralized lending apps have variable borrow rates responding to demand and risk factors dynamically. This impacts profitability.
For instance, if Bob borrows 1 ETH at 8% APY when prices stand at $1,500, but the ETH price spikes to $2,000 increasing borrowing risk, the APY interest rate could surge to 15% raising his costs.
Health factors formula: Collateral Value / Borrowed Amount must exceed liquidation threshold like 150%.
So collateral ratios and rate changes reactively price risk on chain. If health declines near danger zones, proactive paybacks or topping collateral recommended avoiding automatic liquidations.
Liquidation Triggers
If health ratios like collateralization drop below minimums, liquidation events trigger:
- Smart contract automatically seizes borrower collateral
- Sells on open DEX markets at discount
- Repays outstanding borrow with interest
- Returns remaining collateral, if any, to user
Avoiding undercollateralization critical as discounts means forfeiting one’s deposited assets supporting the borrow position.
For example, if Bob shorts 1 ETH at $1,500 borrowing stablecoins, his 2 ETH locked may liquidate at $1,300 if thresholds break. Carefully factor volatility when pledging collateral.
And that covers a tour through DeFi lending risks! In closing…
Conclusion
We’ve explored fundamentals around shorting from risks/rewards, to futures contracts, margin exchanges, options, and DeFi money lego primitives enabling sophisticated trades.
With great power comes great responsibility. Cryptocurrency prices fluctuate severely – but implemented prudently shorts present opportunities balancing portfolios. Master position sizing, collateral factors, stop losses and monitor market shifts with fanatical discipline achieving success.
Yet even pros get rekt in volatile markets. Stay skeptical of bravado – plan conservatively and manage liquidity actively avoiding full ruin. The decentralized blockchain arena waits for noone as novel generations reinvent finance and economies.
Now go judiciously ply your skills charting waves of manias, panics and nascent potentials!
