Most traders understand market mechanics in a linear, progressive fashion. You buy low, you sell high. That’s how you generate profits, correct? Kind of…. Sort of. Like the old aphorism says, there are many ways to skin a proverbial cat. Traders who stick to the traditional approach of purchasing cryptocurrency at a price of X and selling at a price of X + positive integer will certainly yield a profit if markets are bullish.
Unfortunately, traders have learned a lesson or two from the painful lessons of the not-too-distant past. Markets aren’t always trending higher. In fact, most business cycles are characterized by up and down movements in price, otherwise known as variations, fluctuations, oscillations, peaks and troughs, et cetera. This volatility is absolutely necessary for traders to profit from the financial markets.
On the topic of short selling cryptocurrency though, it all begins with picking trusted exchanges to short bitcoin. Let’s begin, shall we?
How Do You Make Money Shorting a Financial Instrument?
Traders who bet against Bitcoin, Ethereum, Litecoin, or other cryptocurrencies are short selling the financial instrument. When you short crypto, you borrow the asset such as BTC, sell it at its current price a.k.a. spot price, and then later on you pay the broker for the underlying asset. An example brings all of this into sharp focus:
Let’s assume you short sell 10 X Bitcoin (BTC) at a price of $3,500 per unit, from a broker. Your liability for these 10 X Bitcoin (BTC) is $35,000. If you believe that the price of Bitcoin (BTC) is going to drop to $3,000 per unit, your total liability at a later date, when you repurchase the 10 X Bitcoin (BTC), drops to $30,000. That $5,000 differential is known as your profit. Getting started with short selling options on crypto requires finding a brokerage that supports short selling.
It is really important to read the rules and regulations of trading when short selling. Some brokerages may call in their loans before the prices have dropped appreciably. Fortunately, short selling is not a new practice – its been around for eons. Traders the world over engage in short selling of stocks, bonds, commodities, currencies, indices, and other financial instruments.
One such option available to you is a contract for difference, otherwise known as a CFD. This derivatives trading instrument does not confer ownership of any BTC; rather it allows you to trade price movements. Short selling has a bearish perspective. In other words, you are expecting the price of the underlying cryptocurrency to drop. If you were bullish about Bitcoin (BTC), you would take a long position and expect the price to appreciate at maturity.
How Does Margin Trading Factor into Shorting?
One of the biggest problems with trading financial instruments like Bitcoin (BTC) is availability of funds. It’s really expensive to trade Bitcoin when the price is several thousand dollars per unit. To alleviate this problem, Bitcoin exchanges allow approved traders to use leverage. It’s sort of like using a car jack to lift up your car, and all you have to do is pump a pedal with your foot. The heavy lifting – the cost of trading – in this case is done by the exchange, but you as the trader ultimately bear the burden.
Recall that your trading budget is the single biggest hurdle to generating substantial profits in the financial markets. A small budget begets small profits, except when margin and leverage come into play. Margin is best defined as the percentage of the trade value that you are required to have on hand in cash in your account. If you trade with 2% margin, that means a $1000 short sell on Bitcoin will only set you back $20. Many brokerages will not be so generous with margin, and the typical ratio is 2:1, or 50% margin.
Trade with Caution
If you are offered margin of 1%, or leverage of 100:1, be wary. A $1,000 cash balance at 100:1 is effectively trading with $100,000. That’s a lot of money to lose if trades go against you. Cryptocurrency traders tend to enjoy margin and the associated leverage when trades go favorably. It’s certainly not appreciated when trades go against you. For example, 50:1 leverage means that your money has 50 X more trading power.
Bitcoin margin trading comes with a caveat: it costs money to borrow funds, and interest rates are high. Various safeguards are in place to protect the exchanges from substantial losses, in the form of funds that must be added to prevent a position from being liquidated. These are margin calls. If a trader is unable to finance the requirements, the trade is automatically closed out.
Unfortunately, liquidation results in a complete loss for the trader. Small movements in cryptocurrency prices can have an outsized impact on your account. A trader with $500 in an account will have that account closed out with 50:1 leverage if Bitcoin’s price drops by $10 (50 X $10 = 500).
There you have it! The short and sweet of how to profit off Bitcoin and crypto shorting and margin trading. Trade with caution and purpose. Make the right calls. Do the research. Trade with a trusted platform.
Video – Cryptocurrencies
Interesting related article: “What is a Short Position?”