Going Short: How Traders Profit From a Declining Cryptocurrency
Trading Analysis

Going Short: How Traders Profit From a Declining Cryptocurrency

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8 months ago

In the crypto market, savvy traders seek to profit from declining cryptocurrency prices — learn how traders can go short on a cryptocurrency in this article.

Going Short: How Traders Profit From a Declining Cryptocurrency

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The cryptocurrency market is incredibly volatile and the sheer quantity of different assets and trading options provides a wealth of opportunities for astute traders.
Though “blue-chip” cryptocurrencies have demonstrated a long-term bullish trend, this is rarely without interruption. Indeed, most cryptocurrencies experience extended periods of decline during a bear market, and can even draw down in value in a bull market.

Read more: What Makes Bull Market Winners So Successful?

Because of this, traders opt to trade on the short side — predicting which cryptocurrencies will decline in value and netting a potentially handsome profit if correct.

Given that it is not uncommon for cryptocurrencies to lose upwards of 99% of their value during a bear market, shorting can be an incredibly lucrative endeavor — provided it is executed correctly.

Read more: Bear Market vs Bull Market.

Nonetheless, many cryptocurrency investors are unaware of how to profit from a declining cryptocurrency. With that in mind, we’ll take a look at seven methods that traders use to short a cryptocurrency.

These are listed in order of difficulty. So if you’re new to trading and crypto, consider sticking with the simpler options until you’ve got a good grasp of things. Furthermore, the risk of loss of shorting a cryptocurrency

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Trade Short/Inverse/Down Tokens

Short (also known as inverse or down) tokens are by far the simplest way to profit from a declining cryptocurrency. These are tokens designed to move in the opposite direction to an underlying cryptocurrency.

For example, you might have a short token designed to track the price of Bitcoin. If Bitcoin’s price decreases, the short token’s price will move in the opposite direction — it’ll increase. This allows short token holders to profit when the associated asset is declining.

Vice versa, if the price of the associated asset increases, the inverse token will lose value.

These use a variety of mechanisms to track and invert the price of an associated asset — generally using a combination of Oracle price feeds and smart contract logic to track the price of the associated asset and modify the token price to provide holders with -1x exposure to the price change.
Inverse tokens are also available in leveraged flavors. These provide leveraged exposure to the inverse of an underlying asset's price movement. For example, if Bitcoin loses 10% of its value, then a 3X BTC BEAR token would gain 30%.

These generally use a rebalancing system to ensure they maintain the correct exposure to the underlying asset at the expected leverage over time.

Learn more about Leveraged Tokens.

Short tokens can typically be bought and sold on both centralized (CEX) and decentralized exchange (DEX) platforms just like regular tokens. They do not need to meet margin or collateralization requirements and do not have liquidation risks.

Unfortunately, just a handful of short tokens currently exist, and most suffer from limited liquidity. Because of this, few cryptocurrencies can be shorted in this way.

Binance is currently one of the few platforms to support DOWN tokens.

Prediction Markets

Cryptocurrency prediction markets are platforms that allow users to wager on the outcome of future events, such as the Bitcoin price reaching $100,000 by December 31, 2024.

These platforms provide an array of markets that users can participate in and decide whether they agree or disagree with the outcome specified in the market details.

Consider the example market below:

The price of Bitcoin will be below $20,000 by 00:00 on July 01, 2023.

Users can choose if they agree with this prediction by buying ‘Yes’ shares in the market or disagree with the prediction by buying ‘No’ shares in the market. The price of each share depends on the ratio of participants on each side.

For a simplified example, if 30% of the participants agree with the outcome and buy 'Yes' shares, the price of a 'Yes' share might be around $0.30, reflecting the perceived 30% chance of Bitcoin's price being below $10,000 by the end of the year. Conversely, the price of a 'No' share might be around $0.70, reflecting the 70% of participants who disagree with the prediction and believe Bitcoin's price will be above $10,000 by the specified time.

This dynamic pricing allows market participants to express their belief in the likelihood of the outcome and potentially profit from it if their prediction is correct.

Once the specified time and date of the market are reached, the market is automatically resolved and those holding winning shares will win. Assuming they paid $0.30 per share, they would then be paid out $0.70 per share (ignoring any fees), while the losers would lose their entire wager.

Read more: What Are Crypto Prediction Markets?

Contract for Difference

A contract for difference, or “CFD” is a powerful financial instrument that allows traders to capitalize on cryptocurrency price movements by going either long or short.

As their name suggests, CFDs are financial contracts that pay the differences in the settlement price between the opening and closing trades — hence contract for difference. Essentially, they allow traders to profit from the price movements of an underlying asset, such as a cryptocurrency, without actually owning the asset itself.

This makes them suitable for traders that don’t want to deal with the complexity of trading, managing, or storing cryptocurrencies, and makes cryptocurrency trading more accessible to those with limited starting capital.

CFD trading is a relatively simple way to trade directional price movements. For example, if you believe Bitcoin's price will fall, then you'd want to sell a Bitcoin CFD. Let's say you sell one Bitcoin CFD at $29,000 and then the price of Bitcoin falls to $25,000 and you want to exit your position to lock in your profits. You'd then close the position, buying the CFD back and locking in the $4,000 difference as profit (less any fees).

Conversely, if the price of Bitcoin is above $29,000 by the time you close your position, you’d incur a loss equal to the closing price minus your entry price.

Cryptocurrency CFDs are typically traded through online brokerage platforms and CFD providers, in most cases, these brokers will also provide access to a broad range of financial markets.

Today, there are dozens of popular cryptocurrency CFD trading platforms, some of the best-known include eToro and IG.

Binary Options

Cryptocurrency binary options are simple financial derivatives that allow traders to make a prediction on whether they believe an asset will go up or down in value by a specified time and date in the future.

In binary options trading, you predict whether an asset's price will rise or fall within a set time. If correct, you receive a fixed payout; if wrong, you lose your investment.

Traders looking to profit from the decline of a cryptocurrency would execute lower options. These provide traders with a fixed payout when the option expires if they are correct in their prediction.

This kind of option is frequently referred to as a “high-low” option and there are dozens of binary options trading platforms — supporting most popular cryptocurrency pairs.

Click here to see a list of active derivatives exchanges, sorted by trading volume.

Binary options are different from typical vanilla options in that they are simple all-or-nothing trades. Binary options are usually European style, hence they can typically only be exercised at expiration unlike American-style vanilla options, which can be exercised at any time prior to expiration.

Some more advanced cryptocurrency traders may choose to trade regular options since they provide increased flexibility and can facilitate more complex trading strategies.

Margin Trading

Currently one of the most popular ways to trade cryptocurrencies on the downside, margin trading allows traders to borrow funds from a third party (such as the exchange or a liquidity provider) to open larger positions than their balance otherwise allows using leverage.

The way it works is simple, to borrow funds you need to hold a certain amount of funds in your margin account. You can then borrow up to an agreed amount from the lender to open your position, this could be up to 100x your margin in some cases, allowing you to open positions much larger than simple spot trading.

This method amplifies potential profits but also potential losses, since your margin will be used to repay the lender if your position runs too far into the negative. In return for borrowing funds from the broker (or other lender), you'll typically need to pay margin interest, which is deducted from the profits when the trade is closed.

Margin trading can be used to profit from a declining cryptocurrency through the process of short selling. The way it works is simple: if you expect a cryptocurrency to fall in price, you can borrow $10,000 worth of the asset from your broker before selling it immediately. If the asset then declines in price by 20%, you can then buy the same amount back for $8,000, repay your loan and pocket the difference as profit.

Most cryptocurrency exchanges will offer a simplified leveraged trading interface to enable you to short cryptocurrency using margin trading — keeping the mechanics of buying the asset, selling it, rebuying it and repaying the loan behind the scenes.

Perpetual Futures

As covered in our futures glossary entry, cryptocurrency futures are a type of financial derivative contract that entitles the holder to buy or sell an asset at an agreed price at an agreed date.
Most cryptocurrency derivatives trading platforms offer a special type of futures contract known as a perpetual future.

Unlike standard futures, perpetuals can be settled at any time, allowing traders to make directional predictions about the market and exit their position whenever they like. This provides increased flexibility and reduces barriers to entry by making futures trading less complex.

Perpetual futures, or “perps” as they’re commonly known, are a staple among experienced cryptocurrency traders due to their unique properties.

Perpetual futures allow traders to go long or short in their chosen market. They are leveraged positions, enabling traders to increase their exposure to the market when working with limited capital. Some exchanges and markets can support up to 100x leverage.

To open a short position using cryptocurrency perps, you'd typically select the 'sell' or 'short' option on your chosen platform's trading interface. The exchange will then sell the contract and initiate a short position. To lock in profits (or accept any losses) the trader would then need to 'buy' back the contract or click the 'close' option to lock in their profit/loss.

When trading perpetual futures, traders should be aware of the unique fees associated with this type of contract — these include the standard maker/taker fee, as well as a funding rate, leverage fees, and in some cases a settlement fee.

Click here for a full list of cryptocurrency derivatives and perpetual swap markets.

DeFi Short Selling

As we previously touched on, it’s possible to use margin trading to easily short sell a cryptocurrency to profit from its decline. This involves taking out a margin loan and then opening a short position on a cryptocurrency via a broker or margin trading platform.

DeFi short selling is a very similar albeit slightly more involved process. The concept is nearly identical, in that you borrow the cryptocurrency you want to short, sell it, then rebuy it at a later date (and hopefully lower price) to pay off your loan. But instead of using a broker, you take out a loan using one of the myriad DeFi lending platforms.

Here’s how it works in practice:

1. Select the cryptocurrency you wish to short

2. Borrow X amount of the cryptocurrency from a supported open lending platform
3. Sell the cryptocurrency on a centralized or decentralized exchange

4. Wait until it falls in price

5. Rebuy X amount of the cryptocurrency and pay off your loan

The benefit of DeFi short selling is that you can profit from declining digital assets that are not supported on margin or derivatives exchanges. So long as the asset is available to borrow via one of the numerous DeFi lending platforms, you can short it.

Bear in mind, borrowing digital assets via these platforms can be more expensive than margin trading, and there are DeFi-specific risks to contend with — such as smart contract exploits and black swan events.

Learn about Aave — one of the leading DeFi money markets.

Disclaimer: Many of the options listed above involve derivatives trading. This has been banned or heavily regulated in some jurisdictions. The information provided in this article is for educational purposes only and does not constitute financial or legal advice. Cryptocurrency trading, especially derivatives, carries a high level of risk and may not be suitable for all investors. Before engaging in any trading activity, it is important to conduct thorough research and, if necessary, consult with a financial advisor or legal professional.

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