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“Short this space and make money that way” – Nouriel Roubini, 2018.
One of many bold statements which entail the notion that Bitcoin will go to zero. Whilst this meets the sentiment of many who entered the space late or never- we know it better and enjoy the memes whilst the silent blockchain revolution propagates.
For the record, “shorting Bitcoin” has nothing to do with the malicious glee some encounter these days. Why and when shorting Bitcoin can make sense will be subject of this post.
While developments in the crypto world are rising rapidly and exciting technological innovations are expected next year, prices of most cryptocurrencies are tumbling.
The reasons for the current losses are manifold. Regardless, temporary price corrections are in principle a healthy process for the long-term development of cryptocurrencies. That is because without an adequate adaptation in the real economy, meaning real demand, excessive prices are difficult to justify.
As always in such market phases, we receive many requests concerning how to participate from falling Bitcoin prices. In view thereof, we will provide a brief introduction to this subject-matter.
Anyone already familiar with the basics of short contracts can jump straight to Chapter 2.
Short sell, short, short contract, put, short sell CFD.. All these terms ultimately denote a contract, the price of which increases when the price of the underlying asset falls. Later, we use the term “short contract.”
A short contract is an agreement between a trader and a broker. The broker provides the trader with a specific asset, for example Bitcoin. The trader then immediately sells the Bitcoin and buys it back later at a lower price at the time he liquidates his position. He then returns the borrowed Bitcoin to the broker and keeps the difference in price.
With a so-called CFD, “Contract for Difference”, the situation is even simpler. Here, brokers and traders agree right from the start that no underlying assets will be traded but only their monetary equivalents.
Important for understanding:
A short contract is issued by an agency and is listed as a self-sufficient asset on exchanges. Although its price is dependent of the underlying asset, it will develop its own price dynamics. The latter are not solely attributable to the price progression of the underlying asset.
Lastly, the agency also determines the fees for buying and selling the short contract.
In case of a Short Squeeze, the price of a short contract reaches such high levels that the holders of the short contract -regardless of the price of the base asset- opt for selling off the short contract. As described above, a sale results in an accumulation of Bitcoin corresponding to the amount of Bitcoins to be returned.
The price of the short contract is falling and demand of the underlying asset is rising at the same time. Both effects lead to a significant downward momentum of the short contract and its price falls exceptionally strongly, since all short contract holders come out of the gates storming. The underlying asset is also affected, hence, rising. A short squeeze often initiates an at least a short-termed turnaround momentum in the underlying asset.
Again: a short squeeze poses a very high risk to the holder of the short contract, as the purchase prices of the short contract can be quickly undercut. In the worst case scenario, an uptrend in the underlying asset is triggered.
The higher the price of the short contract, the greater the risk of a short squeeze. How to estimate such a risk, we will discuss below.
Short contracts are basically an insurance against falling prices. Buying short contracts allows the holder of the asset class hold on to his assets in a bear market without -in an ideal scenario- taking substantial losses during a bear market.
The general term for such an insurance-based investment is called “hedging“. Hedging is conducted by all major market players. Rest assured that all the major Bitcoin holders do not just watch prices tumble and risk losing it all.
However, in order to achieve an actual risk mitigation by means of hedging, a sophisticated hedging strategy is needed which is different in shape and form for each portfolio.
Leverage is a measure of leveraging an asset in a contract. This means betting on a quantity of a underlying asset many times higher than the actual amount of it purchased. If the price of the underlying asset actually develops downwards, the price of the leveraged short contract increases proportionally by that multiple. Nevertheless, the short contract seller also participates proportionally in losses.
An asset to shorten can be compared to borrowing the asset.
You borrow an asset (for example, 10 Bitcoin) at a certain point in time and return that asset later. When the price has gone down, you can keep the difference. As mentioned above, in the case of CFDs, it is not the asset itself that is awarded and returned, but only its prize.
If you had been out and about for a loan as of 10 Bitcoin at a price of $20,000 as of December 17, 2017, you would have received a total value of $200,000 if you sold the asset immediately- which you would have in the case of a short contract. If you were currently returning this equivalent (10 Bitcoin) because you wanted to liquidate your short position, you would only have to pay back a total of about $40,000 (10 x $4000). In this case, the difference of $160,000 would be the short contract profit (minus taxes and fees).s
If, on the other hand, the price of Bitcoin had risen, let’s say to $100,000 per Bitcoin, it would be necessary to shell out 1.000.000 in order to return the 10 Bitcoin if the contract were to be liquidated. In this case, the Agency issuing the short contract would have liquidated your position earlier. The agency has at all times the right to liquidate a short-contract running ‘ in the wrong direction’. This process is called Margin Call. Leverage increases the effect described many times over.
Chart analysis is not a reliable tool, it is not predicting the future. However, fundamental tendencies can be derived which, according to experience, are valid within certain thresholds.
Below, we will analyze the figure above and carry out a rough, purely qualitative risk assessment. In a real scenario, this should be done in terms of numbers on the basis of specific characteristics.
In the upper, large graph, we see Bitcoin’s price trajectory as a blue curve. This is overlaid by the price history of a short contract. The short contract is shown as a candlestick graph consisting of green and red bars.
It can be seen that Bitcoin’s price trajectory has been in a downward trend since December 2017. The price history of the short contract is in an uptrend, but it has significantly more aggressive price fluctuations than its underlying asset, Bitcoin. This is due to the aforementioned market dynamics such as short squeezes.
The RSI (The Relative Strength Index) is shown in the lower graph. The RSI is a price follow indicator and is especially useful for detecting a short-term lows or highs. In this case, it indicates whether the short contract is “oversold” (the curve is below the purple bar) or “overbought” (the curve is above the purple bar).
In the present case, the purchase of a short contract is particularly unattractive. For short-term speculation, a long contract would be a better idea, i.e. a purchase of the underlying asset, which, however, is still in a downward trend.
A turnaround of the trend, at least in the short term, is quite likely, purely on the basis of chart analysis. If the situation continues to deteriorate, that is, if the underlying asset remains or even falls at the level, the short contract becomes more expensive. Hence, the short contract reaches the “overbought” area and a short squeeze becomes likely.
In this case, a situation similar to that in mid-April 2018 could occur. Here, a -different- support was tested in the underlying asset, Bitcoin. The support held and the overbought short contract fell from 40,000 points to 24,000 points, as can be clearly seen from the graph.
In the course of the year 2018, the short contract’s price even fell to 17,000 points, although Bitcoin was permanently entangled within its downward trend.
The latter shows how great the risks are when trading short contracts. Even if the trend is correctly estimated, heavy losses can still occur, as short contracts themselves are subject to the dynamics of supply and demand.
We might have been the first to come up with the above analysis. Certainly, we’re not the only ones anymore.
Two days after this blog post was published, cryptoslate.com published an article raising the question of a short squeeze.
This again leads to increased attention to said scenario, thus making it more likely as more investors in Bitcoin shorts might get nervous.
Trading short contracts is possible on several crypto exchanges. We have tried numerous exchanges and tested them in terms of simplicity, user friendliness, trustworthiness and fees. For the last couple of months, we are only trading shorts on EToro which is -to us- extremely easy to use and offers fair fees. Also, we believe that due to the fact that EToro also handles traditional stocks and commodities, the public attention to this site is much larger which reduces risks.
EToro is a particularly reliable platform for trading short-contracts and is our platform of choice.
The procedure for trading short-contracts is very simple here.
The act of shorting always also includes borrowing, as the base currency price can rise and more money is demanded from the bank than was paid in. Therefore, short contracts are not recommended for traders who have little experience trading securities. We have covered how much money you should invest in crypto in detail here.
If you decide to short Bitcoin, make sure you only invest money you can afford to lose. Also, be sure to stay up to date on current events so you can anticipate any change in the price direction.
Don’t lose money.
Nouriel Roubini mentioned Bitcoin previously. Five years ago in 2013.
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