During 2018, increased regulations and a general slowdown in cryptocurrency trading caused bitcoin (BTC) to shed over 20% of its value – falling from over $17,000 in January to a low of £3152 in December. While the sell-off was catastrophic for some, for others the fall was an opportunity to short-sell bitcoin.
What is bitcoin shorting?
Bitcoin shorting is the act of selling the cryptocurrency in the hope that it falls in value and you can buy it back at a lower price. Traders can then profit from the difference in market price. Short-selling takes the typical mantra of ‘buy low and sell high’ and flips it on its head – while you still buy low and sell high, the trader sells the asset first and buys it back later.
Learn more about short-selling.
Why short-sell bitcoin?
Before you start to short-sell bitcoin, it is important to consider your motivations for doing so. Most traders that short bitcoin have a bearish view on the future of the market. This is often out of scepticism about the popularity of bitcoin, believing that it is nothing more than a fad.
If you take this view, it is extremely important to keep up to date with changes in the industry, as there is growing optimism around the future uses of cryptocurrencies and their underlying technology blockchain. But there are plenty of people shorting bitcoin who still believe in its long-term potential.
The reason for short-selling bitcoin in this case would be to hedge a long exposure. If you already own bitcoin, but believe it is due to fall in the short term, you might decide to reduce your risk by short-selling the digital coin at the same time. This way, if the market falls, you can cover some of the loss to your initial investment with gains on your short position.
Find out more about hedging strategies.
How to short bitcoin in four steps
Short-selling any asset requires a good understanding of the market and a comprehensive knowledge of trading strategies. As the cryptocurrency market is still relatively immature, it can be exciting but also incredibly unpredictable. This makes it even more important that traders take the time to build an understanding of bitcoin.
Bitcoin was created in 2009 by the pseudonymous Satoshi Nakamoto. It is a cryptographically secured digital currency that has no central authority, which has made it an extremely popular method of payment.
As a decentralised currency, it is free from most of the factors – like central banks and interest rates – that impact fiat currencies, but there are still a number of factors that can move the price of bitcoin. These include the supply of bitcoin, public perception, integration into everyday life and growing regulation of exchanges.
Learn more about the bitcoin market and how you can trade it.
Choose how you want to short bitcoin
There are a variety of ways that you can short bitcoin. Here, we take a look at two of the most popular ways of shorting bitcoin: via a broker or via derivative products.
Some bitcoin exchanges will offer short-selling facilities, but this would involve borrowing the actual asset from your broker or a third party and selling it on the market. If the market price did fall, you’d be able to buy the bitcoins back at a lower price, returning the bitcoins to their owner and profiting from the difference in price.
Let’s say that the price of bitcoin was trading at $4000 per BTC, but you thought that the market was set to decline. So, you decide to borrow one BTC from your broker and sell it on the market. One week later, the market did fall to $3250, and you could buy the bitcoin back for the new market price. You could then pay back what you owe to your broker and profit from the difference in price – in this case you would pocket $750, excluding any brokerage charges. But if the market increased instead, you would have to buy the bitcoin back and return it to the party you borrowed it from. So, if the market had risen to $4750 instead, you would have had to buy the BTC back at the new market price and would have made a $750 loss.
A drawback of this method of shorting bitcoin is that it near-impossible to find a party willing to lend you a bitcoin to short-sell in the first place. And even if you did find a willing party, they could recall the bitcoin at any time and you’d have to accept the current market price.
The drawbacks of traditional short-selling have created growing interest in derivative products as an alternative method of short-selling bitcoin. Derivatives are financial instruments that take their price from the underlying market, in this case bitcoin.
With derivatives, there is no need for you to borrow bitcoin from a third party, as you are simply speculating on the future direction of the market. A popular derivative to name are CFDs:
- CFDs are an agreement to exchange the difference in the price of a bitcoin from when the position is opened to when it is closed. You would open a position to sell a bitcoin if you believed it was going to decline in price
CFDs are leveraged, which means that you only need to put down a small initial deposit – known as a margin – in order to receive full market exposure. While short-selling on margin can magnify your profits if the market falls, it can open you up to magnified loss if the market moves against you.
Let’s say that you had chosen to open a position to short-sell bitcoin via CFDs. Using our earlier example, if bitcoin was trading at $4000, you could open a position to sell one BTC. As CFDs are a leveraged product, you would only need to put down a percentage of the value in order to open your position. For example, if your provider’s rate was 50%, you would put down $2000 in this instance.
If the market did fall as you had predicted, you would close your position by buying one BTC at the new market price of $3250. To calculate your profit, you would just have to take the difference between the opening and closing prices: in this case, £4000 - £3250 = $750. And remember, any profit to your CFD trade is calculated by taking the full value of your position, not just the deposit.
However, if the market had risen instead, up to $4750, you would have to buy a bitcoin at the new market price and incur a $750 loss on the CFD trade.
The increased popularity of short-selling has put an even larger downward pressure on the price of bitcoin, as more and more individuals jump on the short-selling bandwagon. However, it is important to remember that there are risks in short-selling.
The largest risk when you are shorting a market is that there is an unlimited downside. When you buy a bitcoin, the loss is capped at the amount that you have bought the coin for. But when you sell a bitcoin, there is no limit on how much the market can move against you and therefore how much loss you might incur.
This is why it is important to learn how to manage your risk before you start to trade. If you are using derivative products, you can attach a guaranteed stop to your bitcoin position that will protect your trade if the market moves against you.
There are a variety of factors that can cause the price of the cryptocurrency to change quickly and dramatically. Although this volatility is what attracts many traders to the bitcoin market, it is also a cause for concern if they have not established a correct methodology for managing risk.
Discover our range of risk management tools with IG Academy’s online courses.
Open your first position and monitor the market
Once you have decided how you’re going to protect yourself, it’s time to open your first short-selling position. It is important to keep an eye on anything that might cause the price of bitcoin to suddenly move. You can monitor changes in the bitcoin market by using IG’s news and trade ideas, which gives you access to expert analysis and information.
Before you start to short-sell bitcoin it is important to understand the process of short-selling and the risks involved. We’ve summarised a few key points:
- Shorting is the practice of borrowing bitcoin to sell on the market, then buy back at a lower price
- Traders do so in the hope of profiting from the difference in price
- Traders short bitcoin for speculative and hedging purposes
- There are a variety of ways to short bitcoin. Popular methods include selling via a broker and using derivative products like CFDs
- Short-selling does involve risks, which is why it is important to create a risk management strategy
- Once you have opened your first short-selling position, you should remain up to date with any changes to the bitcoin market by using news and analysis