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The ability to short, or create a position where you benefit from decreases in the price, an asset is a powerful way to either make or lose money fast. Unlike a long position, short positions can give you infinite exposure. Instead of risking your capital up to the amount of the purchase, you are risking your capital to the maximum the security could rise to: infinite.
The Mechanics of Shorting
Obviously Bitcoin won’t hit the theoretical infinite, but a bigger worry is that as the price continues to rise, the capital you have in your account is considered insufficient to cover the short. Brokerages are naturally skittish about shorts because you have yet to “pay” them, so they have to be careful about whether you can cover your losses. Because of this, they often make those taking a short position provide significant capital as collateral.
Bitcoin’s volatility makes it a prime risky asset when shorting in the traditional manner. The frequent spikes in prices can trigger a squeeze, which then require short sellers to buy back Bitcoin, pushing the price even higher in a self-perpetuating loop.
It was one thing to want to short Bitcoin when it was reaching its peak at the end of December, but now this feels like an overplayed move. Past patterns with both Bitcoin and business cycles in general have shown that bubbles tend to go in 3 or 4 year cycles. This is likely a low for Bitcoin, and the technology is continuing to advance. Most of all, there isn’t much “give” left in the price and the longer it trades around the $6K and $7K levels, the more that becomes its “accepted” value by the market as a whole.
Methods of Shorting
The traditional method of shorting involves selling off Bitcoin you have borrowed, waiting for the price to drop, and then buying it back. This method is risky for all the reasons we mentioned above, and there are much more elegant ways to execute this trade with a similar payoff.
The three most interesting ways are using futures markets, binary options, or prediction markets. Futures markets allow for traders to buy or sell Bitcoin at a specified price and date in the future. The user locks in a price that reflects their position on the security, and then waits. The CBOE is just starting to offer derivatives like this for Bitcoin, and there are several other options which are gaining steam.
It is actually generally acknowledged that the unveiling of Bitcoin futures in December 2017 contributed greatly to the run up in price (and eventual collapse). Futures generally bring some added volatility when they are first introduced, so this was expected, but many investors took Bitcoin having futures to trade as a sign of cryptocurrencies having a new level of legitimacy. A short-term surge in prices was expected, but with Bitcoin having such a low level of liquidity across the exchanges, a massive and unsustainable run-up in the price occurred, and we are still dealing with the aftermath.
If a trader were to want to short Bitcoin using futures contract, they could do one of two things. First, they could buy futures with a strike price (the price they buy the Bitcoin at according to the contract) lower than the current price of Bitcoin. This is the less risky move, because the downside is capped. Additionally, they could sell futures at the current price or a price higher than the current price. This would be considered riskier because Bitcoin could theoretically go up an infinite amount, leaving the shortseller with a significant liability.
Binary options are similar, but instead of setting up a guaranteed trade at a certain price, it becomes possible to buy or sell the right to transact at a certain price. This approaches more of a “bet” on where the security is going, and the only capital at risk (assuming you are buying puts) is the amount you spend buying the options.
Finally, there are prediction markets, which is essentially a way of gambling on the future price of Bitcoin. This is a burgeoning aspect of the ecosystem, but is still less risky than executing a traditional short. Predictious is one example of a company that allows for these bets to be made. You can choose to buy a contract that pays you 10 m฿ if you are correct about your price prediction, and nothing if it doesn’t. For example, at the time of publishing, it cost 4.85 m฿ to bet that Bitcoin would be above $100,000 by the end of 2018.
Do You Really Want to Short Bitcoin?
So, in short, you should be very careful when you are shorting something as volatile as Bitcoin. There are many assets which you can more confidently short, such as major retailers on their way to going out of business, or any other company whose competitive moat is clearly threatened at this point in time. But shorting Bitcoin in the traditional way is not something to take lightly.
Since futures were introduced in late 2017, Bitcoin’s price has dropped significantly. But additionally, the volatility of crypto has dropped as well. It is likely that the ability to price in bets about the future prices of Bitcoin using futures has brought additional stability to its price.
The biggest downside to shorting Bitcoin is the unlimited upside. With an asset as volatile as Bitcoin, it is possible that the price gets bid up to the point of you getting “short squeezed” and having to close your position. As we saw in late 2017, no one knows where the price of Bitcoin is going and you don’t want to leave yourself overly exposed to losses. Your best option, if you do choose to follow this route, is to use binary options, which results in the most limited downside to your trade.
Featured image courtesy of Shutterstock.
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