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EducationalDecember 31, 2018

The Ultimate Guide to Shorting Bitcoin

Jitender Tokas
Chief Business Officer
December 31, 2018

Ability to short sell is an important feature in any well-functioning financial market. Short sellers are essentially betting on prices going down and thus, help curb excessive or irrational exuberance that leads to unjustified price increases, sometimes even bubbles. In fact, the 20x increase in price of bitcoin in 2017 could be partially attributed to absence of products that allow shorting bitcoin. Cryptocurrency trading markets have since evolved rapidly and now there exists a wide variety of markets/ trading venues that enable a trader to short bitcoin and several other leading altcoins such as Ether and Ripple. In this article, I briefly discuss what is short selling, why it is important, followed by a comprehensive list of ways in which bitcoin can be shorted. I will also prove that currently crypto futures are the best way to short bitcoin and other cryptocurrencies.

What is short selling?

As we will see below, short sale of an asset can be achieved in a multitude of ways. Regardless of the method, the economic substance of the transaction remains the same – the short seller profits when the prices of the asset fall.

Why is short selling important?

Short sale serves as a natural hedge against over optimism in markets. Imagine a world where you could not short bitcoin. In such a world, if you thought bitcoin was over-priced, all you could do was to not hold any bitcoin. But would it not be better if you could act upon this view instead of just sitting out of the market?!

This is exactly what short selling enables traders to do. When traders are able to express both positive and negative views about price of an asset through their trades, (a) better price discovery happens, (b) rationality in prices tends to prevail and (c) price volatility goes down.

Ways to short bitcoin

1. Short bitcoin using futures

Futures are standardised derivative contracts that trade on exchange like Delta, and enable traders to bet on rise or decline in the price of an asset without actually owning it. Moreover, these bets through futures are leveraged which helps to amplify the PnL from such trades.

Futures are arguably the best way to short cryptos because they:

  • Offer high leverage: You can typically get very high leverage when you trade cryptocurrency futures. For e.g. on bitcoin futures, Delta offers 100x leverage. This means that with $100, you can buy or sell bitcoin futures worth $10,000.
  • Are very liquid: Cryptocurrency futures market is several cases are much more liquid than the spot market. This means that you can take large positions without incurring much impact cost.
  • Have lower fees: Trading fees on futures exchanges are much lower compared to the fees charged by spot exchange. For example, trading feesfor the bitcoin futures on Delta are 0.075% for takers and -0.025% for makers. In contrast, the fee for trading bitcoin on Binance is 0.1%.

Where can you trade bitcoin Futures

Bitcoin futures are offered by both traditional financial exchanges like CME and CBOE as well as crypto-only derivatives exchanges like Delta and BitMex. The traditional exchanges have mature technology, long track record and strong familiarity among traders. On the other hand, crypto-only futures exchanges have been built to handle the idiosyncrasies of crypto markets (24/7/365 trading, predominantly retail traders that are multi-lingual and are from all over the globe).

2. Short bitcoin through margin trading

Short sale via margin trading is achieved by selling bitcoins that you don’t own. This means, that you borrow bitcoins by providing some collateral, and sell them. If bitcoin price goes down, you can buy them back cheaper in the future and return them to the borrower with interest. The % decline in bitcoin price is what you make on this trade.

It would be worth noting a few things here:

  • the capital required to enter this trade is the collateral you provide for borrowing bitcoins. Usually, margin positions are partially collateralised (for e.g. for borrowing bitcoins worth $100, only $20 in collateral might be required) resulting in leverage.
  • Borrow markets are separate from trading markets. For example, you could borrow bitcoins from a broker and sell them on an exchange like Binance. There are however exchange that run both borrow. and trading market

Shorting bitcoin or any other cryptocurrency through margin trading has the same effect has selling futures. However, futures trump margin trading because of the following features:

  • Higher leverage: Maximum leverage on futures trading could be as high as 100x, while the same for margin trading is typically limited to 2-5x.
  • Higher liquidity: Liquidity on margin trading tends to be constrained by borrow markets. In contrast, futures markets tend to be highly liquid.
  • More options: You can short only bitcoin and few other leading altcoins through margin trading. But for other coins, margin trading is not available. For instance, if you want to short XLM, the only option you have is to use the XLM futures on Delta.

For a detailed comparison of futures and margin trading, please check out this blog post.

Where can you margin trade bitcoin

Margin trading is being offered only at a handful of crypto exchanges. These include Bitfinex, Huobi and Quoine.

3. Short bitcoin using CFD

CFDs are contract for difference. Much like a futures contract, they are a type of derivative that offer the same functionalities: (a) go long/ short an asset without having to trade it directly and (b) high leverage. However, there are some key differences as well:

  • Futures are standardised exchange traded contracts. In contrast, CFDs are offered by retail brokers. This has some important implications. An exchange has open order books which enables peer-to-peer trading and consequently results in better prices and lower fees. In a CFD, you are always trading against your broker. Being the sole liquidity providers, brokers often offer poor prices and charge higher fees.
  • In Futures, the interest rate is built into the price itself. Whereas, interest rate (for providing leverage) is charged by the broker on a daily basis. This interest rate can fluctuate over time.

Where can you trade bitcoin CFDs

Bitcoin and other crypto CFDs are offered by a plethora of retail brokers. These include Plus500, eTorro, InterTrader etc.

4. Short bitcoin using options

Options are a type of derivative contract. In this contract, the option seller grants the option buyer the right, but not obligation, to buy or sell an asset at a pre-fixed price. This pre-fixed price is called the strike price of the option. There are two way in which you could short bitcoin using options:

  • Selling a call option on bitcoin: This option gives the buyer right to buy bitcoin at the strike price. The buyer will exercise this right only if market price of bitcoin is higher than the strike price. Thus, if bitcoin price goes down, the option would expire worthless and the option seller will pocket the sale price of the call option. It is important to note that this is the maximum amount the seller can make on the trade, while his downside is infinite.
  • Buying a put option on bitcoin: This option gives the buyer right to sell bitcoin at the strike price. The buyer will exercise this right only if market price of bitcoin is lower than the strike price. In case, bitcoin price is higher than the strike price, the option expires worthless. As is evident, maximum loss for the buyer is limited to the price of the option, while the upside can be significant.

Options are far more complex derivatives compared to futures and should be traded only by savvy traders. If you are new to options, it might be prudent to restrict your trading to only buying options. This is because selling options can expose you to significant losses.

Where can you trade bitcoin options

Currently there are no mature/ liquid markets available for trading options on cryptocurrencies. Your choice is mostly limited to Deribit, which offers option only on bitcoin. However, even at Deribit, the liquidity in options fairly thin.

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