Many people have made money from Bitcoin's meteoric rise in price over the first half of 2019. Since March, prices rose from $3,800 to more than $10,500, nearing their all-time highs of around $20,000 in late 2017. Facebook's introduction of Libra — a new cryptocurrency backed by major banks and government organizations — injected further confidence into the crypto markets and sent coins higher across the board.
While it's easy to profit from an increase in price — by purchasing cryptocurrencies and waiting for them to increase in value — it's not as obvious how traders and investors that believe cryptocurrencies are overdue for a correction can profit from a decline in price. How can you bet on the decline in the value of a cryptocurrency over time?
In this article, we will take a look at how short selling enables investors to hedge risk and traders to bet on a decline in price, as well as how to short sell cryptocurrencies and the risks associated with the strategy.
What is Short Selling?
Short selling is a strategy to profit from a decrease in an asset’s value. Short-term traders use the strategy to speculate on a temporary decrease in price, while long-term investors or portfolio managers may use it to hedge risk. The only requirement is a margin account with a broker or exchange that's willing to participate in short sales for a given asset, such as a stock, commodity, fiat currency or cryptocurrency.
The process is simple for most securities:
- You borrow the asset from someone that owns it.
- You sell the borrowed asset immediately for cash.
- You repurchase the asset after it has decreased in value.
- You return the asset to the lender and profit from the difference.
Short selling requires the use of a margin account since you're effectively borrowing capital. While the short position is open, you may have to pay interest on the value of the borrowed amount, as you would for any traditional loan. You may also be required to post collateral to secure the loan, particularly if the value of the borrowed shares increases and the cash value of your repayment liability increases.
Let's take a look at an example:
Suppose that Google Inc. (NASDAQ: GOOG) is trading at $1,000 per share and you believe that they're going to decrease in value. You call up your broker and ask to borrow ten shares, and then sell them for $10,000 in cash. If Google shares fall to $900 per share, you buy back the ten shares for $9,000, return them to the broker and realize a $1,000 profit. On the other hand, if Google shares rise to $1,100 per share, your short position would have a net unrealized loss of $100.
Short selling is commonplace in the securities market where most large companies have at least some short interest.
For instance, Tesla Inc. (NASDAQ: TSLA) has over 40 million shares sold short worth over $9 billion in total value, as of July 2019. These are shares that that short sellers borrowed with an agreement to repurchase them at a later date.
While the maximum loss for a long position is limited to 100 percent — or a complete loss of your original investment, the maximum loss from short selling is theoretically unlimited. Bitcoin prices could rise to $100,000. If you shorted the cryptocurrency at $10,000, you could lose $90,000 on an initial ‘investment’ of just $10,000, or nine times the original amount. This makes short selling much riskier than long trades or investments.
How to Short Cryptocurrencies
The cryptocurrency market isn't as developed as conventional securities markets, which means that short selling is a little more difficult. Many crypto exchanges don't let non-accredited investors short sell currencies and they may only permit short selling on a few currencies, and only a handful of stock brokers provide access to Bitcoin futures contracts. After all, brokers and exchanges are on the hook for losses you can’t repay.
Some of the most popular ways to short sell cryptocurrencies include:
- Margin Trading: Crypto exchanges that permit short selling will lend you cryptocurrency that you can immediately sell with an agreement to buy it back in the future. You may have to meet certain criteria to qualify to borrow, adhere to certain borrowing limits and pay fees and interest. Kraken, Poloniex and other crypto exchanges permit these kind of short sales to some degree.
- Prediction Markets: There are several so-called prediction markets that let you bet on where crypto prices are headed within a certain margin or price band. These bets are made without the use of any cryptocurrencies in the same way as sports betting. Some examples include Augur, Stox and Cultivatelabs.
- Futures Markets: The newly launched Bitcoin futures market enables traders to bet on future price movements — including downward ones. In order to short a futures contract, you can sell a call option or buy a put option through a brokerage account. Brokers like TDAmeritade and E*Trade support the buying and selling of Bitcoin futures through the CME and other futures exchanges.
The tax treatment of short selling is similar to traditional buying and selling with a few exceptions. For instance, the holding period for short selling is based on the amount of time that you actually held the property (e.g. borrowed shares) rather than the length of the position, so almost all short sales are short-term capital gains. It’s important to keep detailed records of these transactions to properly compute the tax consequences.
ZenLedger makes it easy to track many of these cryptocurrency transactions. Rather than manually calculating prices, you can connect exchanges and wallets to import transactions and have instant access to prices. The platform even separates short-term and long-term capital gains, as well as auto-populates common tax forms, like Form 8949 and Form 1040 Schedule D.
Sign up for ZenLedger today to simplify your cryptocurrency tax reporting.
The Bottom Line
Short selling is a strategy designed to let long-term investors hedge their risk and short-term traders profit from a decrease in asset value. Unlike long positions, short positions have unlimited risk since an asset could theoretically experience an infinite increase in price. Traders should tread carefully when using short selling strategies and carefully record their transactions for tax purposes.