If you believe that the price of a certain asset will decrease, you can potentially make a profit by selling that asset ‘short’. In traditional markets such as the stock market, selling something would first require you to own it. Usually, your broker facilitates the borrowing process. However, it may not always be practically feasible. In contrast, you are now able to trade cryptocurrencies short and open any volume of long and short positions at any time, assuming there is enough liquidity in the market without borrowing.
You may be wondering at this point, how can you sell an asset before you buy it? What does it mean to open a long or a short position? And, how does financial leverage work?
To make things clearer, let us review these simple yet very important concepts in more detail and what makes trading cryptocurrencies short so exciting.
When you open a long position, it means that you are buying something with the hope that the price will appreciate and you will make a profit by selling it at the higher price. When you open a short position or “sell short,” you are technically selling at the higher price first with the hopes that the price will depreciate and then you will buy at the lower price locking in that profit. The goal of margin trading is to make your money go a longer way. Margin trading platforms offer traders different amounts of leverage or multiples of the amount money they deposit (margin). So in order to buy 1 Bitcoin that costs $4,000, you only need $400 of your own money to purchase it if you’re being given 10x leverage. You will reap the benefit of the leverage if your trade moves in the right direction (upwards if you are long and downwards if you are short). Conversely, if the trade moves in the wrong direction against, you will lose your money 5 times faster.
WHAT MAKES TRADING SHORT SO EXCITING?
Market downward trends may be as significant and prolonged as upward trends
The market moves in regular, repeated waves or cycles. Every series of waves moving up in a bull market is being followed by a series of corrective waves moving down in a bear market, and vice versa. This reflects the nature of how price discovery mechanisms work in financial market. Therefore, in margin trading, the concept of a downward trend is as important as the concept of an upward trend, and the ability to sell assets short can be as profitable during a declining market as the ability to buy assets long during a rising market.
Markets tend to decline faster than they grow
This observation occurs due to a variety of reasons. Negative geopolitical and macroeconomic events tend to disrupt market prices and revaluation often occurs instantaneously. Deteriorating fundamentals of a particular asset may cause its price to decline dramatically to reflect a new fair value. Another important factor is associated with human psychology and the fact that the fear of losing money is a stronger emotion than greed. When people feel fear observing a declining market, they tend to exit their long positions quickly and massively, which perpetuates falling prices. In such periods, it becomes possible to make abnormal returns faster by short selling than waiting for a recovery and going long.
The 1987 US stock market crash, when markets declined by 22% in one day;
The technology market crash of 2000, which caused a market decline of 78% over two years;
The 2008 financial crisis, which caused a market decline of 57% over two years;
A more recent market crash on May 6, 201 (the “flash crash”), when US equity and futures prices dropped nearly 10% in a matter of minutes.
Bitcoin experienced an 80% decrease in price over 2014 as well as in 2018.
Margin trading platforms have facilitated trading in both directions through leveraged accounts. If it were not for these platforms, the only way to trade cryptos short would be to sell the cryptocurrency, wait for it to go down, and then buy it back (assuming you held some already). This is certainly less sophisticated. Whether you’re a trader, holder, optimist, pessimist, or anything in between, you are able to trade on your beliefs through such platforms. It is important to remember that you should always educate yourself on the risks of trading with leverage or margin trading. Just like everything else in life, the more you learn, the better you’ll become... with a little luck on your side.