By Hassan Mehmood (Saudi Arabia)
Introduction
Investing in stocks and commodities has its roots in mathematics and economics. Therefore, investors who have a proven track record in the aforementioned fields have been able to introduce new tricks and formulate new methods of trading to make profits. One such method is called shorting.
Shorting is a type of trading strategy that enables investors to generate profits despite asset devaluation. For new investors, the meaning of earning money from investing is to place bets on options that are constantly increasing in value.
However, with shorting, investors can learn to keep their profit income steady during times when the market is not travelling in a positive direction.
What does Shorting Mean in Crypto?
Shorting Cryptocurrency means the order where the investors are trying to sell their assets for a higher price and repurchase the same cryptocurrencies for a lower value later. In this situation, the investors can make use of the declining prices of a cryptocurrency.
Traditionally speaking, a cryptocurrency investor searches for a currency that is doing well and tries to purchase an undervalued cryptocurrency that has the potential to climb in price later. In this manner, the investors can make profits with the difference between their purchase prices and the current market value of the cryptocurrency. However, with shorting, the dynamic is reversed.
How does Shorting Work?
For a trader who is only getting started with trading, shorting can seem like a complicated concept. However, using a simple example, the reader might be able to better understand the idea.
Take, for instance, Mr. X, who wishes to purchase a new cryptocurrency called orange. After performing a technical analysis and reading the fundamentals of orange, Mr. X concludes that the current market value of the orange coin has a considerable possibility of declining in the next quarter. Rather than looking for appreciating cryptocurrencies, Mr. X decided to short the orange coin.
He goes to his broker and asks him to sell ten orange coins for 100 USD. In this manner, his trading account now has a balance of negative ten orange coins. However, as indicated by the technical analysis, the prices of orange coins dropped from 10 USD per unit to 5 units per unit after a few weeks.
Now, Mr. X can purchase 20 orange coins from the market and complete his shorting contract with the buyers. Now, Mr. X has 10 orange coins in his portfolio, and his purchase cost is balanced. He sold 10 orange coins for 100 USD and purchased 20 orange coins for the same amount. In the end, he earned a profit of 10 orange coins by shorting the method.
Origin of Shorting
The earliest use of shorting techniques has been traced back to the 17th century in the Netherlands. A prominent investor, shareholder, and entrepreneur of the Dutch East India Company named Isaac Le Marie has penned down several detailed records of short dealings in the Amsterdam Stock Exchange.
However, his shorting account portrayed the practice as unethical and complex to follow. Another important record of shorting can be traced back to the collapse of Neal, James, Fordyce, and the Down Bank of London in 1772. The incident also propagated the decline of several banks in Scotland and created a massive liquidity crisis in London and Amsterdam.
The infamous Dutch Tulip market bubble in the 18th century is also attributed to shorting. George Soros is one of the most well-known short market sellers who rose to fame in 1992 when he broke the Bank of England by shorting more than $10 billion worth of pound sterling currency.
19th Century investor Jacob Little is known as the Great Bear of Wall Street on account of his stock shorting sprees in the USA markets during 1822. Australian investor Alfred Winslow founded a hedge fund when he was shorting stocks and hedging market risks in 1949.
During the dot-com bubble of the 90s, many investors attributed the worsening condition of the market to short-sellers who were trying to drag the prices of stocks as low as possible. In the same vein, the 2008 housing bubble struggling financial giants such as Morgan Stanley, Lehman Brothers, and HBOs created massive short positions that destabilized the stock markets.
It is clear that whenever the investment markets are crashing or about to experience a decline, some traders are ready to take advantage of the opportunity using shorting techniques.
Types of Shorting
Before diving into how to short cryptocurrencies in detail, it is important to understand different types of shorting techniques. There are the following basic types of shorting:
Naked Shorting
Naked shorting is an example of when investors short assets without owning them at all. It means that a person can short an asset such as stocks or cryptocurrencies without having any of the assets in their reserves at all. It entails that the person can sell the asset in question without having the said investing product.
However, some countries consider this practice illegal. For example, conducting naked shorting with equities in the USA is barred by the law, and investors cannot short stocks that are not already part of their trading portfolios.
Covered Shorting
Covered Shorting is a technique in which the investor borrows shorting stocks or assets from a lending authority. In this manner, they have to pay a borrow-rate fee based on the duration of their shorting period.
Margin Shorting
Margin Shorting is not a classification of shorting. However, many investors borrow money to short sell. Therefore, investors need to understand how it works. Margin is the amount of balance that an investor has to maintain in their trading account to manage the credit risks for brokers and exchange markets.
As per the Federal Reserve Board, all shorting investors must maintain a 150% value of their short positions in their accounts to avoid getting a margin call.
Key Factors for Shorting Cryptocurrencies
It is important to note that shorting is a trading technique that is developed by equity traders. However, the laws and technical dynamics that work for stocks are not the same when it comes to cryptocurrencies. Therefore, investors should take their time to measure the dynamics related to cryptocurrency trading before creating a new shorting plan for their trading journey. Here are some of the key factors that investing with short positions with cryptocurrencies should keep in mind:
Technical Analysis
Investors with short positions tend to use the Dow Theory as a baseline reference for their positions. The six tenets of Dow Theory guide the investors about the fundamental indicators and core technical variables that are responsible for trend reversals.
Therefore, short investors need to pay attention to technical drivers and indicators to read the market movements.
Technical Analytics
Here are the most important and rudimentary technical variables that investors can use to predict an upcoming retracement or crash:
Bollinger Bands: Bollinger Band is a useful metric that determines whether the current price of an asset is high or low with the sample trading period.
Relative Strength Index (RSI): This index allows investors to read the magnitude of the price change based on the latest changes.
Average Directional Index (ADI): This indicator is great for measuring the strength and maturity of the current trend concerning any asset.
Standard Deviation: This indicator is used to measure the annual return rate on a particular investment position and determine the historical validity of an investment option.
Indicators
Just like the aforementioned technical analytic options. Investors should also make use of the following indicators to perfect their shorting positions:
- Fibonacci Ratios and their Extensions.
- Moving Averages or MAs.
- Time-weighted Average Prices or TWAPs.
- Volume-weighted Average Prices or VWAPs.
News and Market Speculation
For long positions, investors are often discouraged from depending on the media and news. However, speculative forces can play an important role in bringing down the prices of a cryptocurrency.
Therefore, short investors should always pay heed to the market news and look out for any sudden market changes, such as sudden legislative changes by the government or internal organizational conflicts, etc.
At the same time, short position holders should also stay alert about any policy changes that can impact their positions negatively.
Shorting during Bull Markets
At first glance, it can seem like a sudden rally is a nightmare scenario for a short seller. However, in some cases, the sudden market rally is a delayed reward for short position holders.
In most cases, a sharp increase in the purchasing pressure for an asset is the result of FOMO that drives the prices of the cryptocurrency up temporarily. This artificially inflated price is the ideal place for an investor to create a short position.
As soon as the hypes die down, prices drop exponentially. And thus, the short investors can enjoy massive profits.
Fundamental Analysis
By focusing on the Qualitative and Quantitative qualities related to Fundamental Analysis for cryptocurrencies, investors can increase their chances of success. At one end, investors can focus on quantitative aspects of FA, such as trading volume, demand, supply, ratios, and formulas.
On the other hand, they can ascertain the declining probability based on qualitative features of FA, such as standard, intrinsic value, market sentiment, and others. Using FA, investors can determine whether a cryptocurrency is undervalued or overvalued and create winning shorting positions based on that data.
On-Chain Statistics
Thanks to the current technology and the internet, just about every trader can gain access to the on-chain metrics. On-chain metrics refer to the data analytics based on the dynamics happening within a blockchain or a DeFi ecosystem.
Most investors use cryptocurrency exchanges and other trading platforms for selling and purchasing cryptocurrencies. Every trading application provides auto-generated on-chain statistics and their derivatives.
At the same time, investors with a little knowledge of programming can also extract the data directly from a blockchain network such as Bitcoin and use it to ascertain the technical analytics results.
Transaction Frequency
The trading volume or the total number of transactions for a cryptocurrency can also grant traders a clear picture of its demand and future direction. However, investors should always use this metric with caution as different cryptocurrency aggregators, and analytics websites portray a varied version of trading volume depending on the analyst who is publishing these projections.
At the same time, a high transaction count can also be a result of an active whale investor or fund transfers between different trading wallets.
Value of Transaction
Transaction value determines the total worth of the fund transferred based on accumulation value for a specified trading period. This metric allows the investors to read the current trend and market sentiment related to a particular cryptocurrency.
7 Methods of Shorting Bitcoin
Bitcoin is often regarded as the flagship cryptocurrency. Investors who want to learn about shorting cryptocurrencies can broaden their horizons by learning about the seven different methods of shorting used with Bitcoin. With a suitable amount of variations, investors can use these techniques to short any cryptocurrency:
Inverse Exchange Traded Funds or ETFs
Inverse ETFs are derivatives that bet that the underlying asset is going to experience a price decline. Therefore, the Inverse ETFs are also compared with futures contracts. For Bitcoin investors in the USA, there is only one ETF, namely BITI by ProShares. On the other hand, Bitcoin traders in Canada can use BITI by BetaPro and Short Bitcoin ETP by 21Shares in European countries.
Contract for Difference or CFDs
Contract for Difference, or CFD is a legal trading contract that creates profits based on the differences between the opening and closing prices of an asset. Bitcoin CFDs are often compared with Bitcoin futures contracts. The investors who want to short Bitcoin purchase a CFD based on the prediction of a price decline.
CFD trading is more flexible than futures because the settlement date is not predetermined. At the same time, CFD traders can also pair the performance of Bitcoin based on a fiat currency or concerning other cryptocurrencies.
Short-selling Assets
Short-selling Bitcoin is the Naked Short selling method. The investors who engage in this method of shorting need to have a strong risk appetite. Furthermore, the investors need to account for hidden costs such as custodial fees by Bitcoin digital wallet service providers.
At the same time, the shorting trader must also consider the highly volatile nature of Bitcoin prices. Some exchange platforms offer leverage for shoring Bitcoin. However, a slight shift in the Bitcoin prices can trigger a margin call and put the investor under a mountain of losses and debt.
Prediction Markets
Prediction markets are places where investors earn money by issuing positive or negative predictions about the performance of a certain asset. The investors who wish to short Bitcoin take up price downgrade positions.
If another investor accepts the bet, the investors can make profits if Bitcoin prices decline on the exact ratio decline or margin. Some of the most used Bitcoin prediction markets are Polymarket, Augur, and GnosisDAO.
Binary Options Trading
Binary options for Bitcoin trading are available on several international Bitcoin exchanges, such as OKEx and Deribit. In options trading, when an investor wishes to create a shorting position, they draw a put order. Put options signify that the investors will be able to sell a cryptocurrency at its current market value even if the prices decline later.
Binary options are more risk averse than futures because the investors can choose not to sell their put option in case of an unwarranted price increase and limit their losses to put option purchase cost.
Futures Trading
A Futures contract is a trading certificate that predetermines the price and the time for the purchase of an asset in the future. The short investors have to sell a futures contract to side with the bearish market sentiment.
On the other hand, investors can also purchase futures contracts that bet on price decline for Bitcoin. Bitcoin futures shorting gained traction in 2017, and it has now spread to some of the most popular trading forums, such as the Chicago Mercantile Exchange or CME.
Investors can access Futures contracts using platforms like eToro, TD Ameritrade, Kraken, and BitMEX, among others.
Margin Trading
Margin Trading is one of the most popular types of shorting techniques for cryptocurrency investors. Investors can borrow money from their brokers or exchange service providers to place a shoring bet. However, the investors need to make sure to maintain the minimum collateral to avoid the margin call.
Therefore, margin trading carries a massive probability of trading risks. Some major exchanges that provide margin trading features are Kraken and Binance, among others.
Conclusion
Shorting cryptocurrency is a high-risk trading strategy. However, by understanding the important dynamics around shorting, investors can increase their chances of success and increase their profits.
At the same time, investors should also account for the related risks and hidden costs that are associated with shorting to make sure that their profits are not dissolved into expenses despite exerting so much energy. Furthermore, shorting can exhaust an investor psychologically on account of the constantly changing dynamics of cryptocurrencies. With preparations and careful planning, investors can succeed in shorting cryptocurrencies.
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