How to Short Crypto and Risks to Consider
The essence of trading is simple: buy cheap and sell dear. This is the most common earning strategy, but not everyone knows that there are other ways to make money in exchange trading. For example, many traders earn by shorting their assets. The following guide from AdroFx will explain what a short position is and how to make money from it.
What is Short Selling, and How Does It Work in Crypto?
Shorting a cryptocurrency is selling coins in order to buy them back later at a lower price. The interesting part of this strategy is that the trader does not own the cryptocurrency on which they are planning to make money. To understand the concept of shorting, you need to understand what a long and short position in the cryptocurrency market is. A long position is buying a cryptocurrency when its price is expected to rise. For example, you buy an altcoin for $10 and expect its price to rise to $12. And as soon as the price rises, that altcoin is sold at a profit.
And a short position is borrowing and selling a cryptocurrency when its price is expected to fall. Thus, when the price falls, you buy such a cryptocurrency and make a profit from the difference in the selling and buying price.
Here's an example:
- You plan to sell one bitcoin for $25,000 because you expect the price to fall in the next few days.
- You borrow a bitcoin from a broker and sell it for $25,000.
- A few days after the sale, the BTC drops to $20,000.
- Then you buy one bitcoin for $20,000 and return it to the broker.
- That way you make $5,000 minus the interest you have to pay the broker for the loan.
Short selling is taking advantage of a decrease in the price of an asset. This strategy is worth resorting to when the market price of an asset is expected to decline. However, shorting cryptocurrency can be quite risky because the market is unpredictable. There is a chance of both making and losing money due to volatility.
Long positions are less risky – the price of the asset may fall, but not to zero, and you will suffer losses, but the investment will not burn out. But opening a short position may cause the price of the asset to rise indefinitely, and with it your losses. That is why before entering into a short position, you should carefully study the market. If you are sure that the price is sure to fall, then the risk becomes justified.
Why Short Cryptocurrency
Cryptocurrency short selling can have different reasons, depending on how much you plan to earn and how the market has been studied. Here are the most common reasons.
Difference in price
Sometimes the price can be overblown, or the coin can be significantly overvalued for one reason or another. Traders notice such situations and take advantage of them:
They sell the cryptocurrency and wait for its price to fall. To determine when to sell a currency, you should use a fundamental method of analysis and estimate its intrinsic value relative to the market price.
Volatility can be discouraging to cautious investors, but it can also be beneficial. Cryptocurrency prices can rise as fast as they fall.
Risk-averse traders are attracted to these fluctuations because there is money to be made on them. However, this requires a proper level of experience and knowledge of trends.
Volatility negatively affects long positions. Suppose you already have bitcoin in your portfolio, but you expect its price to fall. In that case, you can open a short position on that coin.
If the drop happens, the profit from such short selling can cover the losses on the long position. Simply put, a hedging strategy helps to reduce the risk of trading in a bear market.
Risks of Short Selling
While shorting cryptocurrencies is a good way to make money, it also has its risks. Here are the most dangerous of them.
If you buy a cryptocurrency in order to sell it at a higher price in the future, you only run the risk that the price will not rise to the planned level.
So, you will keep the purchased asset in your hands, and you can hold it for as long as you want.
When shorting a cryptocurrency, on the other hand, the possible losses are limitless. If the price of the asset rises without stopping, you may have to borrow it again, but at a higher price, in order to cover the costs without losses.
You shouldn't forget that when you short a cryptocurrency, you don't actually own it. You simply borrow it from a broker, who will charge you interest until the loan is paid back.
And if the price of the cryptocurrency is not as predicted, you may have to hold it longer than planned. And the longer the position is open, the more commission you will have to pay.
How Can You Short a Cryptocurrency?
Before shorting a cryptocurrency, the first thing to do is to find the right market trend. The cryptocurrency market is very volatile and can change rapidly in any direction due to many factors. For example, cryptocurrencies are influenced by political events, "hype" or mentions by famous personalities.
Before selling, determine the trend of the cryptocurrency and see if it is influenced by a major company or celebrity. Once the trend is determined, you need to create a margin trading account. Most cryptocurrency brokers offer this service. Also, check the regulatory requirements of your country and make sure you won't violate any of them.
So, we've figured out what cryptocurrency shorting is, now let's find out what methods there are for short selling.
Direct Short Selling
This is the most popular way of shorting bitcoin and other cryptocurrencies. So, you simply borrow the cryptocurrency from the exchange at a certain price and sell it.
Then you have to wait for the price to fall, buy the sold asset and return the loan to the exchange. Profit is made from the difference in the purchase and sale prices.
Some cryptocurrencies have futures markets where the asset is bought under contract. The contract specifies the price at which the asset will be sold and when it will happen.
By buying a futures contract, you are betting on the price of the asset to rise. This allows you to profit from that asset in the future. By selling a futures contract, traders expect the price to fall amid a general market decline.
Contracts for Difference
Contracts for difference are one of the most popular ways to short-sell cryptocurrencies. These contracts allow you to bet on the rise or fall of a cryptocurrency.
There is no need to own the asset itself - all you need to do is deposit some funds to confirm that you can buy the cryptocurrency at the price specified in the contract. The deposited funds remain at your disposal, and the exchange or broker holds them only as collateral.
Thus, to open a position, you only need to deposit a certain percentage of the total transaction amount. And if the cryptocurrency moves in the direction in which you made the bet, then the return on investment (ROI) increases. However, this method comes with huge risks: if the price of the currency changes in the wrong direction, you will suffer losses.
Cryptocurrency put options
Is it possible to short a cryptocurrency without putting your investment at risk? Yes and no. If you have a good understanding of derivatives, you can also try cryptocurrency put options.
Such an option gives you the right to sell a coin at a predetermined price on a specified date. It is also important to note that an option only gives you the right to sell, but does not oblige you to do so.
For example, if you expect bitcoin to fall in the future, you can buy a three-month put option on bitcoin with a strike price of $20,000. If, after three months, the bitcoin price falls below the strike price, the purchased put option will make a profit.
And if the price does not fall, you will only lose the option premium - the fee you paid to buy the option.
If you want to learn how to short cryptocurrency while interacting with other investors, then look at prediction markets. These markets are similar to traditional markets.
In them, investors predict changes in the price of various cryptocurrencies. And other market participants can "join" your prediction, and if it comes true, you will make a profit.
Tips For Shorting Cryptocurrency
The success of shorting a cryptocurrency depends on several factors, so make sure you choose the right approach before starting such a trade. After all, the last thing you want to encounter is shorting a cryptocurrency during a false correction. Here are a few tips on how to short a cryptocurrency correctly.
Use technical analysis
Technical analysis is the use of real data to predict how the crypto market will behave in the future. It examines the past performance of a particular asset.
So, if you are planning to short bitcoin, you must first compare the trading volume of BTC for the current day with the volume in the past months.
Technical analysis is partly based on Dow's theory, which states that market pricing depends on a number of factors: regulations, current, past, and future demand for the cryptocurrency, and traders' expectations.
The essence of technical analysis is that history is cyclical and trends and prices change according to a steady algorithm. The information obtained through technical analysis is used to predict future changes in the market.
Moreover, technical analysis is based on the idea that any change in the crypto market is not random, but based on trends, both short-term and long-term. So, if an asset follows a trend, that trend will eventually reverse.
Here are some indicators used in technical analysis:
- Average Directional Index (ADX) – helps determine the "strength" of a trend;
- Bollinger Bands – shows whether an asset's price is low or high by using the comparative principle;
- Standard Deviation – Applies to the annual rate of return on investment and assesses the reasonableness of investing in a particular asset based on historical data;
- Relative Strength Index (RSI) – assesses the "momentum" of a change and helps determine the "strength" of a trend.
These indicators help determine the potential profitability of a planned investment. You can also use various statistical tools, such as Fibonacci, Time Weighted Average Price (TWAP), Volume Weighted Average Price (VWAP), and Moving Averages (MA).
Please note that for shorting bitcoin and any other cryptocurrencies, it is crucial to understand the Moving Averages indicator. In simple words, an MA is the price of a cryptocurrency over a certain period. As a rule, an MA depends on the market price of the asset for the last 20 days. In order to increase the accuracy of forecasting, several MAs are used simultaneously, the data from which is combined.
However, this is a rather complicated statistical concept, which takes some time to study. If you are a beginner and are still just learning how to short cryptocurrencies, you probably try to avoid such complicated economic topics. We highly recommend that you thoroughly study all of the indicators presented, despite their complexity, as they help to significantly improve your investment performance.
Follow the news
That's right - news from any sector, be it the cryptocurrency sector or the economic-political arena, can have the strongest impact on the market. Government "crackdowns" and regulations can lead to severe declines in the crypto market.
If you expect changes in the world to affect the market soon, you can benefit from this situation. However, make sure that you do not violate any regulatory requirements, as this could get you into serious trouble.
Short a cryptocurrency in a rising market
Is it okay to short cryptocurrency during unexpected market rallies? Absolutely. This is the best time to short-sell any cryptocurrency. During such rallies, assets get overbought due to the prevailing fear of missing out syndrome (FOMO) in the market. But when the hype subsides, the asset returns to its original value or even falls, creating an opportunity for short traders to make money.
Use fundamental analysis
Some experts believe that cryptocurrency is not subject to any "fundamentals" because its markets are still very young. However, it is an undeniable fact that fundamental analysis helps increase the chance of making good investment decisions.
It helps determine the forces that control supply and demand for the cryptocurrency you're interested in. For example, demand is influenced by market sentiment, news, trading volumes, adoption rates, and transactional activity.
Fundamental analysis determines the intrinsic value of a cryptocurrency. The state of the asset (undervalued or overvalued) is established based on internal and external factors. Three main indicators are used for fundamental analysis of the cryptocurrency market:
- Blockchain data
Intrinsic indicators help in assessing the state of an asset. By the way, it is not necessary to go to the blockchain and look at the indicators yourself – many websites offer ready-made statistics.
- Transaction count
Transaction counts help measure blockchain activity. Using MAs and charts over a certain period, you can determine how actively a cryptocurrency is trading over time.
However, this indicator should be treated with caution. For example, this indicator cannot determine whether transactions are made between different people, or simply between different wallets of the same person.
- Transaction amount
Transaction amount measures the amount of funds transferred over a certain period. Suppose 10 bitcoins were transferred in a day, and the price of each bitcoin is $20,000. Then the transaction amount for that day would be $200,000.
Selling cryptocurrency can bring a trader quite a high income even against the backdrop of a general market decline. If you trade on the exchange but do not use short strategies - it is not a full-fledged trade. Market participants should be able to make money under any circumstances and trends, and to do that, they need to be able to play both up and down.
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