There was a time when short selling, the tactic of betting a security will fall in value, had a bad reputation. Investing was supposed to be an optimistic enterprise in which money was allocated to promising businesses with rising share prices and shareholders reaped ample returns. That’s called going long, and it’s the most common way to invest in the capital markets. To profit from the misfortune of companies and a falling stock price was deemed cynical and critics decried those who did as bottom feeders.
Maybe so, yet short sellers have long played a key role in the markets by unearthing weak companies, and by exposing those that commit fraud or falsify their financial data. Short sellers keep markets efficient and, to a degree, honest. They don’t act out of altruism—they also can profit from their research by taking positions that will gain in value after the bad news hits and securities prices tumble.
To be an effective short seller, traders must be ruthless and have a cast iron stomach for the risks. In cryptocurrencies, those traits are even more important.
What is short selling?
In its most basic form, short sellers borrow shares of a targeted company, sell them at the current market price, and agree to return the shares in the future. They’re betting a stock’s value will tumble by the time they have to buy back the shares and settle the loan.
If the share price drops a lot and is cheaper than when the short seller borrowed the stock, the result is a windfall. If the opposite happens and the share price soars, the trader will suffer steep losses.
Can you short crypto?
The short answer is yes. Digital assets, rife with fraud and subject to little regulation, are ripe for savvy shorts who can take advantage of a volatile market. If an investor believes Bitcoin or Ethereum’s Ether token are going to fall in price they can place trades to profit from that conviction.
The question is how. There are a number of ways to take a bearish position on a digital asset, including the use of derivatives, a sophisticated type of investment contract whose value is based on some underlying asset. Each comes with its own pros and cons. Moreover, some crypto investors like to mix short selling into their long portfolios to protect themselves from sudden reversals in a bull market. That tactic is called hedging.
How to short crypto
There are several ways to bet on price declines in cryptocurrencies:
- Margin trading. Some exchanges permit investors to borrow Bitcoin and pay back the tokens at a later date. This is similar to classic short-selling of stocks—the trick is to repurchase the tokens for less than when they were sold. Exchanges may agree to provide leverage, or debt, to maximize an investor’s bet. That’s known as trading on margin.
- Futures contracts. These derivatives permit investors to wager on the future prices of Bitcoin and Ether. The instruments are traded right alongside stock market futures at the Chicago Mercantile Exchange. Investors who want to bet on declines can agree to sell Bitcoin futures at a lower value than the spot price today, then accumulate the Bitcoin as it falls in the interim. This is, in effect, a short sale.
- Options and puts. Investors can also use another form of derivative: options and puts. The former lets investors commit to buy a security at a future date for a predetermined strike price. The latter enables investors to sell at a strike price. Puts are typically used to make bearish bets because they let the holders set a lower price and enforce the sale. When the spot price drops below the strike price the put-holder’s trade is said to be in the money, or profitable.
- Contracts-for-difference. These derivative instruments, known as CFDs, are agreements in which a seller agrees to pay a buyer the difference between an asset’s market value and the value when the contract was drawn up. They are prohibited in the U.S. because they are not traded on exchanges but rather over-the-counter directly between two different parties. Investors in the U.K. and Asia frequently use them to short-sell Bitcoin and Ether. CFDs function similarly to futures but they typically don’t have settlement dates so investors can carry the positions with more flexibility.
- Exchange-traded funds. In June 2022, fund provider ProShares introduced an ETF designed for investors who want to short Bitcoin. The product, which is called BITI and trades on the New York Stock Exchange, uses futures contracts to express its bearish bias. There are bound to be others following its lead in making it easier to bet against cryptocurrencies.
What are the risks of short-selling cryptocurrencies?
Because markets tend to rise over time, betting against the flow can be riskier than going with it.
The greatest danger in short-selling is when a targeted security continues to increase in value week after week rather than decline. With each jump in price, the short-seller will move even further away from the break even point. Theoretically, the losses could be infinite because there’s no limit to how high a security can rise. At least with going long there is a hard floor to potential losses—when the security’s value hits zero, leaving the investor with nothing.
Shorting cryptocurrencies is even riskier than shorting stocks because crypto markets are driven primarily by short-term speculation and random events. If Elon Musk tweets support for Bitcoin, the price of Bitcoin could soar in a matter of minutes. Over the past decade, Bitcoin and Ether have embarked on bull runs primarily driven by market sentiment, not their financial performance or adoption by consumers. As a technology used in daily life, crypto remains a marginal proposition.
Finally, it’s extremely difficult to predict the performance of cryptocurrencies. While economic data and the financial disclosures of companies are indispensable in helping investors size up stocks, there is no equivalent in crypto. Bitcoin is not a company with a product, service, sales, and profits—it's a digital token that exists on a computer network.
Are there restrictions on shorting?
Regulators in the U.S. and Europe have urged retail investors to be careful when short selling cryptocurrencies because losses can rapidly pile up. Typically, it’s hedge funds and other professional investors that use short-selling tactics. As a result, it is much easier for accredited investors—those registered and licensed with the Financial Industry Regulatory Authority—to short-sell crypto.
In 2020, the U.K.’s Financial Conduct Authority banned the sale of cryptocurrency derivatives to retail investors. The European Union has done likewise, preventing investors from tapping the instruments to make short bets.
There are no outright federal prohibitions on short-selling digital assets in the U.S. Many discount brokerages and crypto exchanges, including Robinhood, Binance, Coinbase, and Kraken, permit customers to use derivative contracts to short-sell Bitcoin and its ilk. Yet some, such as TD Ameritrade, limit short-selling to approved customers deemed capable of understanding the risks involved—and of absorbing the potential losses.
While there are thousands of so-called altcoins—basically, anything other than Bitcoin or Ethereum—many are too thinly traded to support short-selling and the bulk of such trades are executed with Bitcoin and Ether.
The bottom line
There are many ways for investors to bet against Bitcoin and Ether and sell them short. These often involve derivatives such as futures contracts, which can be difficult to understand for those who aren’t professional traders or accredited investors.
Betting against the market is a time-honored practice that can restore a sense of balance, especially in moments when markets become overheated. And investors often use short-selling as a hedge against losses in their portfolios.
Yet, cryptocurrencies are much harder to assess than stocks. They are driven primarily by momentum and investor sentiment rather than economic fundamentals. And because tokens are not operational companies, Bitcoin and its counterparts can’t provide investors with financial data to inform their trading decisions.