What is Crypto Short Selling?
By Beluga Research July 23, 2023
- Crypto short selling is the practice of borrowing a set amount of a cryptocurrency and selling to buy it back at a lower price
- This occurs when an investor anticipates a decline in the price of a crypto asset
- An investor will lose money if the price of the cryptocurrency significantly increases
- Investors can also lose money if the interest on the borrowed amount starts to exceed expectations
Crypto short selling is the practice of borrowing a set amount of a cryptocurrency and selling it, to buy it back at a lower price. The investor makes a profit on the difference in the two prices. An investor typically borrows the cryptocurrency from a lending platform or another investor. A party usually engages in crypto short selling if they believe the price of a cryptocurrency will drop.
Crypto short selling is a risky strategy. The practice is made more complex when investors interact with stablecoins. These are cryptocurrencies like Tether (USDT) that are pegged to fiat currencies like the U.S. dollar. The question with short selling such assets is whether there is enough of the reserve assets to effectively back the coin.
An investor can lose money if the price of the asset increases instead of decreases. They can also lose money if the interest rate on the amount they have borrowed is higher than expected.
A Brief History
The cryptocurrency market began to see short selling occur in the early 2010s. Bitfinex, a cryptocurrency exchange, was one of the first exchanges to allow the short selling of bitcoin. Other exchanges have since followed suit. Crypto short selling is now a popular strategy for investors. When an exchange is involved in short selling, it sets the interest rates for lending and borrowing. An exchange may charge a fee for use of its services. It can also offer rewards to lenders who offer use of cryptocurrency in large amounts or for long periods of time.
What is Crypto Short Selling?
Crypto short selling is the practice of borrowing a cryptocurrency, selling it and later buying it back at a lower price. An investor typically uses an exchange to engage in the practice. The investor makes a profit when the selling price is higher than the buy-back price.
An investor can engage in crypto short selling on margin. This involves the investor borrowing more than they have in an account. Crypto short selling on margin increases potential profit, but also risk. If an investor loses money, they may need to close the short position by buying back the borrowed shares at the lower price. The investor does this to avoid losing more money than they have in their account.
Crypto short selling is subject to market manipulation. Investors with large amounts of coins can sell holdings to drive down the price. This causes a chain reaction. Other investors will sell holdings and further drive down the price.
- Find an exchange that supports short selling. Not all platforms offer the feature.
- Create an account and deposit funds. This requires providing some personal data and placing crypto or fiat with an exchange.
- Select the cryptocurrency to short sell. Then enter the amount to sell and the duration of the trade. The platform will execute the trade for an investor.
- High volatility. Cryptocurrencies are notoriously volatile. Crypto short selling can be riskier than short selling traditional assets like stocks.
- Decentralized interactions. Crypto short selling that involves one investor borrowing an amount of cryptocurrency from another is a move away from centralization and the involvement of intermediaries like banks. The lender of the cryptocurrency has an opportunity to earn interest from the interaction in a secure manner that is free from third-party interference.
- Potential for market manipulation. The cryptocurrency market is largely unregulated. It is possible for large investors to manipulate the market to their advantage. This can make it difficult for smaller investors to short sell cryptocurrencies without being affected by market manipulation.
- Requires a different mindset than traditional investing . Short selling involves betting against the market. This can be a difficult mental hurdle to overcome for investors who think in terms of buying and holding.
- Profitability . Crypto short selling allows investors to make a profit when the market is falling. This is useful when the investor believes that the price of a cryptocurrency will decrease.
- Hedging . Short selling can be used as a hedging strategy to protect a portfolio from potential losses. Crypto short selling can offset potential losses from other investments.
- Diversification . Short selling allows investors to diversify their portfolio by taking advantage of rising and falling markets. This can help reduce the overall risk of portfolios.
- Flexibility . The flexibility of crypto short selling is useful in volatile markets in which prices change rapidly.
- Decentralization . The lack of third-party involvement in some crypto short selling interactions increases the amount of decentralization in the cryptocurrency ecosystem. If an investor uses an exchange to engage in crypto short selling, the exchange benefits by seeing more activity and having more user involvement.
- Unlimited loss potential . In many situations, crypto short selling can have unlimited loss potential. An investor who buys a cryptocurrency may see their maximum loss limited to the amount of investment.
- Margin call risk. Crypto short selling often requires investors to borrow cryptocurrency from a broker. If the price of a cryptocurrency being shorted rises too much, the broker may issue a margin call. This requires an investor to deposit additional funds to cover their losses.
- Counterparty risk. Crypto short selling requires investors to borrow cryptocurrency from a broker. This introduces counterparty risk. The investor depends on the broker to provide cryptocurrency to short. If the broker is unable to provide the cryptocurrency, the investor may be forced to close their position at a loss.
- Limited availability. Short selling may not be available for all cryptocurrencies. Some exchanges may not offer the option to short certain cryptocurrencies.