What are the Risks of Shorting Bitcoin?

2/18/2023, 3:53:27 AM - Henry Chikwem
What are the Risks of Shorting Bitcoin?

With the evolution of the crypto market, investors have been able to come up with various ways in which they can profit in the market. One of the ways is through crypto short selling.

Crypto short-selling is a trading strategy where an investor decides to sell a crypto asset that he does not own. This is usually the case if the investor believes that the price of the crypto will fall.

Shorting bitcoin

Key Takeaways

• To be successful at bitcoin shorting, you will have to have a perfect understanding of the bitcoin market price trends.

• With traditional bitcoin shorting, the risk involved is high as the price of bitcoin could increase instead of decrease, causing you to lose funds.

• Given how unpredictable Bitcoin and other cryptocurrencies are, caution should be taken when using the short-selling strategy.

• CFD is a simplified way of engaging in bitcoin shorting without worrying too much about the price of bitcoin moving against your prediction.

While this is profitable, it does not come without some risks, which we shall look at in this article with Bitcoin as our focus.

SEE ALSO: CFD Trading – How to Make the Best Use of It

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What is Bitcoin Shorting?

Bitcoin shorting occurs when you decide to sell bitcoin with the expectation that its price will drop in the future so that you can buy it back at a lower price, profiting from it in the process.

Bitcoin shorting is usually done by investors who are optimistic about bitcoin and cryptocurrencies in general. For this reason, it is important to do proper research before you decide to do bitcoin shorting.

Additionally, you could decide to short sell your bitcoin to minimize perceived future risk if you believe its price will fall in the future.

That way, if that happens, you will be able to gain some profit from the bitcoin shorting, which will cover the loss incurred due to the fall in price.

With changing trends, Bitcoin and other cryptocurrencies are gaining a lot of relevance across industries.

How to Short Bitcoin

How to short bitcoin

There are several ways you can go if you want to short bitcoin. However, two major ways you can short bitcoin include traditional short selling and derivatives trading.

Traditional short-selling

How to short bitcoin

Traditional short-selling entails short-selling bitcoin the original way, which involves borrowing bitcoin 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 price difference.

A typical example is given to explain this below:

Assume bitcoin is currently trading at $20,000 per BTC and you are expecting the price to drop. Because of this, you decide to borrow one bitcoin from your broker and sell it on the market.

Three days later, the price falls to $15,000, and you can buy the bitcoin back for the new market price.

You could then pay back what you owe to your broker and profit from the price difference—in this case, you would pocket $5000, excluding any brokerage charges. 

But if the price 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 $25000 instead, you would have had to buy the BTC back at the new market price and would have made a $5000 loss.

One major weakness of the traditional short-selling method is that it is almost impossible to find a party willing to lend you bitcoin to short-sell in the first place.

Even if you did find one, they could take back their bitcoin at any time leaving you to accept the current market price.

Derivatives Trading

How to short bitcoin

This method is an improvement from the traditional short-selling method, and it involves making use of a financial instrument known as a contract for difference (CFD).

A contract for difference is an agreement to exchange the difference in the price of a bitcoin between the opening and closing positions. You would open a position to sell a bitcoin if you believed its price would decline.

CFDs are leveraged, which means that you only need to put down a small initial deposit – known as a margin – 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.

Risks of shorting Bitcoin

While shorting bitcoin can be quite profitable, it comes with some risks of its own which are explained below:

Price volatility of Bitcoin

When you buy and hold bitcoin, with the belief that its price will increase in the future, you won’t be incurring any losses if the price does not end up going up as you predicted.

You will only end up with your initial bitcoin and can continue to hold it for as long as you wish.

Whereas when you hold bitcoin with the belief that its price will drop, failure for it to do so will mean that you would be incurring losses as you go beyond the initial investment.

To offset this loss you might be forced to borrow it at a higher price to lower your average cost.

Margin Interest

It is important to remember that when you short sell Bitcoin, you don’t own the cryptocurrency. Instead, you’re borrowing it from a broker, who charges you interest for as long as you hold the crypto.
Suppose Bitcoin’s price doesn’t decrease per your predictions, you may end up holding it for a long time. While this rise is happening, the interest keeps piling up, eating a major part of your profits.

Absence of a standard regulatory framework for Bitcoin
Some of the biggest futures trading venues of Bitcoin are not regulated. This means that investors have fewer recourse options if something goes wrong with their trade.

Frequently Asked Questions (FAQs)

Can I short Bitcoin using leverage?

Yes, you can. Many cryptocurrency exchanges like Binance and futures trading platforms allow the use of leverage or borrowed money to place bets on a fall in Bitcoin’s price.

Bear in mind, however, that leverage use can magnify gains and losses. Therefore, the risk when using leverage is proportionally greater.

What are some of the most common ways to short Bitcoin?

The most common way to short Bitcoin is through traditional short selling and derivatives trading.

Final Thoughts

Shorting Bitcoin and other cryptocurrencies is one of the ways you can profit from the crypto market. 

But exercising due diligence should be mandatory to guarantee that predictions are accurate and losses are avoided.

With bitcoin’s price constantly changing, it is never a bad time to make some profit off of it.

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