Risks of shorting crypto

In cryptocurrency trading, the standard mantra is almost always "buy low, sell high." This traditional long strategy is intuitive: you buy an asset, hold it as it appreciates and sell it for a profit. However, sophisticated traders often flip this script by using a strategy known as short selling, or shorting, which aims to "sell high, buy low." This approach allows traders to profit when prices fall, making it a popular strategy during bear markets or for hedging existing portfolios against downturns.

While the prospect of making money as the market bleeds is appealing, shorting is an advanced strategy that carries unique, asymmetrical risks that differ significantly from spot trading. Unlike a long position, in which the worst-case scenario is the price dropping to zero, shorting exposes traders to dangers such as short squeezes, liquidation cascades and theoretically unlimited losses. This article explores the mechanics of shorting, and details the potential financial risks involved in betting against the market.

Key Takeaways:

• Short selling theoretically exposes traders to unlimited losses — because asset prices have no upward cap, unlike long positions, in which loss is limited to the investment.

• Volatility and leverage can trigger rapid liquidations and short squeezes, forcing traders to buy back assets at inflated prices.

• Ongoing costs, such as funding rates and margin interest, can erode profits if a short position is held for an extended period.

What does it mean to short crypto?

In simple terms, shorting (or short selling) is a trading strategy used when an investor anticipates that the price of an asset will decline. Unlike buying an asset to hold, shorting involves selling an asset that you don’t actually own at the time of the sale.

The mechanic relies on borrowing. You borrow the cryptocurrency from a lender (usually the exchange), sell it immediately at the current market price and wait for the price to drop. Once the price falls, you buy the same amount of the asset back at the lower price and return it to the lender. The difference between the initial selling price and the lower repurchase price constitutes your profit.

For example, imagine Bitcoin is trading at $60,000. You believe it will drop to $50,000. You borrow 1 BTC and sell it, pocketing $60,000 in cash (or stablecoins). A week later, Bitcoin drops to $50,000. You buy 1 BTC back for $50,000 and return it to the lender. You’re left with a profit of $10,000, excluding any transaction fees or interest.

Traders generally choose to short digital assets for three primary reasons: 

• The most common one is to profit from bear markets, allowing them to generate returns even when the broader market is in the red. 

• Another key reason is hedging: a trader might hold a long-term Bitcoin portfolio, but short Bitcoin futures during a temporary dip in order to offset losses in their main holdings. 

• Finally, traders short-sell based on valuation or skepticism, betting against assets they believe are overvalued bubbles that are destined to burst.

How do short positions work on crypto exchanges?

In traditional finance, shorting often involves a complex process of manually locating shares to borrow from a broker. In the cryptocurrency market, however, this process is streamlined and automated via digital asset exchanges such as Bybit. Traders rarely interact directly with a lender. Instead, the exchange facilitates the borrowing and selling process instantly.

There are two main ways to execute this type of short sell: 

• With margin trading, you borrow funds or assets directly from the exchange's liquidity pool to sell on the spot market. To do this, you must provide collateral, known as margin, to cover the loan.

• The second (and more common) method is through derivatives, specifically futures or perpetual contracts. When shorting via futures, traders don’t necessarily need to borrow the underlying asset itself. Instead, they buy a contract that derives its value from the cryptocurrency. In this case, a short futures position increases in value as the underlying asset's price declines.

The process generally follows three steps. First, the trader opens the position by placing a sell/short order. Secondly, they provide margin (collateral) to secure the position. Finally, to realize profit or loss, they close the position by buying back the asset or contract (covering) at the new market price.

The unlimited loss risk

The most critical concept to grasp regarding short selling is its asymmetric risk profile as compared to long positions. For example, when you take a long position by buying $1,000 worth of Bitcoin, your risk is defined and capped. The worst thing that can happen is that Bitcoin's price falls to $0. In that catastrophic scenario, you lose your initial $1,000 investment, or 100% of your capital. You cannot lose more than you put in.

A short position functions entirely differently. If you short $1,000 worth of Bitcoin, you’re betting the price will drop. However, there’s no mathematical limit to how high an asset's price can rise. If Bitcoin's price doubles, you lose $1,000. If it triples, you lose $2,000. If the price increases tenfold, your liability scales proportionately. Because an asset's price theoretically can rise to infinity, your potential loss on a short position is, at least theoretically, infinite.

Consider a trader who shorts a low-cap altcoin at $10. If positive news breaks, and the coin’s value shoots up to $100, the trader must buy it back at $100 to close the loan. This results in a large loss that far exceeds the initial trade value. 

This potential for unbounded loss is what makes shorting inherently more dangerous than buying and holding.

How volatility makes it unpredictable to short crypto

Cryptocurrency markets are notorious for their extreme volatility, which adds a layer of unpredictability to short selling. While traditional assets like those in the S&P 500 have historically shown annualized volatility of around 11%, Bitcoin has historically shown annualized volatility closer to 40%, with smaller altcoins exhibiting even wilder swings.

Unlike traditional stock markets that close for the night and weekends, crypto markets operate 24/7. This continuous trading means that news, regulatory announcements or sudden movements by whales can cause double-digit percentage price spikes in a matter of minutes — at any time of day or night.

For a short seller, this volatility is perilous. Sudden price spikes can trigger stop-loss orders prematurely, forcing an exit at a loss before the market resumes its downward trend. It can also cause slippage, which takes place when the execution of a buyback order occurs at a much worse price than planned because the price is moving so rapidly against the trader.

Short squeezes and rapid price reversals

A short squeeze is one of the most feared events for anyone betting against the market. It’s a feedback loop in which rising prices force short sellers to buy back their positions to cut losses (known as covering). Since covering a short involves buying the asset, this wave of buying pressure drives the price even higher. As the price climbs, more short sellers are forced to cover, creating a domino effect of buying that sends the asset’s price vertical.

Short squeezes are often triggered by unexpected bullish news, a high level of short interest (when a trade is too crowded with sellers), or low liquidity (a low float of available tokens). When too many traders are positioned on one side of the boat, it takes very little to tip it over.

History provides stark examples of this phenomenon. The GameStop saga in 2021 saw retail traders coordinate to buy shares, forcing hedge funds to cover their shorts at astronomical losses. Similarly, the Volkswagen squeeze of 2008 briefly made that car manufacturer the most valuable company in the world. 

In the crypto world, smaller altcoins with low liquidity are highly susceptible to these mechanics. Traders often monitor metrics, such as short interest or days to cover, in order to gauge the likelihood of a squeeze occurring.

Liquidation risk: When prices move against you

In the context of margin and derivatives trading, liquidation is the process by which an exchange forcibly closes your position to prevent you from accruing a negative balance that you cannot repay. This happens when your margin balance falls below the maintenance margin requirement.

It’s vital to understand that forced closure doesn’t wait until a trader's balance hits $0. Instead, the liquidation engine activates the moment the available collateral drops below the maintenance margin level. This threshold acts as a safety buffer: if adverse market movements reduce a trader's equity below this specific limit, the system automatically intervenes in order to close the trade and settle the loan.

To maintain a fair trading environment, leading platforms like Bybit use the mark price instead of the last price as the trigger for liquidations. Since the mark price is an aggregate derived from multiple global spot exchanges, this creates a composite index. This method protects traders from market manipulation or isolated price anomalies on a single platform, thus ensuring that positions aren't closed due to artificial volatility. 

For a short position, liquidation occurs when an asset’s price rises to a specific liquidation price. If you do not have a stop-loss in place, hitting this price results in the total loss of your initial margin.

Funding rates and the costs of holding short positions

Holding a short position isn’t free, and its costs can erode profitability over time. In the perpetual futures market, traders exchange payments known as funding rates. These payments are designed to anchor the contract price to the underlying spot price.

The risk for short sellers arises when market sentiment is bearish. If the perpetual price trades lower than the spot price, the funding rate typically turns negative. In this scenario, traders holding short positions must pay fees to traders holding long positions.

When a trader holds a large short position during a period in which shorts are paying longs, these fees are deducted directly from their margin balance, often every eight hours. Over time, this expense can significantly erode profits or — worse — lower the trader's effective margin, bringing the liquidation price closer even if the asset's price hasn't moved much. Furthermore, in standard margin trading, traders must pay hourly interest on their borrowed coins, regardless of market direction, which adds another layer of cost to the strategy.

Low liquidity and slippage during crypto market spikes

Liquidity refers to how easily an asset can be bought or sold without impacting its price. Slippage is the difference between the expected price of a trade and the price at which the trade is actually executed. These two concepts — liquidity and slippage — are deeply intertwined risks for short sellers.

During a sudden market spike, at the exact moment a short seller desperately needs to exit or buy back their position, liquidity can dry up. If the order book is thin, meaning there are few sellers willing to sell at the current price, the trader's buy order will eat through the order book as it fills at progressively higher prices.

The result is that the trader is forced to buy back the asset at a much higher average price than the screen showed when the trader clicked the button. This exacerbates losses significantly. Such a scenario is particularly common when traders are shorting illiquid altcoins, since a single large buy order can shift the price by a large percentage.

Emotional pressure and decision-making while shorting

Shorting exacts a heavy psychological toll that shouldn’t be underestimated. The general market trend for cryptocurrency has historically been upward over the long term. But shorting requires the trader to fight this dominant trend, which can be stressful and isolating for them.

The stress of unlimited loss potential adds immense pressure. Traders often experience panic when a shorted asset pumps slightly, leading them to exit positions prematurely in order to protect capital — potentially only to watch the price dump shortly after.

This is essentially fear of missing out (FOMO) in reverse: panic covering to prevent loss. The mental fortitude required to hold a short position while the market moves against you is significantly higher than that required to hold a long position, when you can simply wait for a recovery without the threat of owing more than your investment.

How leverage amplifies shorting risks

Leverage involves using borrowed funds to increase the size of a trading position. For example, using 10x leverage allows a trader with $1,000 to open a position worth $10,000. While this amplifies potential profits, it amplifies risks to an equal or even greater degree.

The math of leverage works against the short seller during a price rise. With 10x leverage, a mere 10% rise in the asset's price results in a 100% loss of the initial margin, triggering liquidation. However, if a trader uses 50x leverage, a 2% price rise is enough to wipe out their position.

High leverage compresses the gap between the entry price and the liquidation price. In volatile crypto markets, a move of 2% or 10% can occur in a moment. By using high leverage, a trader leaves virtually no room for normal market volatility, thus turning trading into a gamble where any minor fluctuation can result in a total loss.

Risk management strategies for short sellers

To survive the dangers of shorting, robust risk management is essential. The most non-negotiable tool is the stop-loss order. A stop-loss order defines a maximum loss point and automatically exits the trade if the price rises to that level, preventing a poor trade from becoming a catastrophic one.

Position sizing is equally important. Traders should never go all in on a short position. A common rule is to risk only a small percentage, such as 1% to 2%, of your total portfolio on any single trade.

Using lower leverage is another vital strategy. Sticking to 2x–5x leverage, rather than 50x or 100x, allows for breathing room. It enables a trade to withstand normal volatility without hitting the liquidation price.

Advanced traders may also use hedging strategies, such as buying a call option. A call option gives you the right to buy an asset at a specific price, effectively capping the potential losses on your short position if the price skyrockets. Finally, using isolated margin instead of cross margin is recommended. Isolated margin limits risk to only the funds allocated to that specific trade, whereas cross margin puts your entire account balance at risk.

When shorting may be unsuitable for traders

There are specific market conditions and trader profiles for which shorting is simply too dangerous. During strong bull markets, shorting is akin to stepping in front of a freight train. Attempting to pick the top during a parabolic run is a high-probability way to lose money.

Similarly, shorting new listings or meme coins is incredibly risky. These assets have unknown price discovery ceilings, and are prone to violent volatility driven by social media sentiment. 

Finally, beginning traders should generally avoid shorting. Until a trader deeply understands market mechanics, order books and leverage, they should stick to spot trading — or extremely low leverage — in order to avoid the pitfalls discussed above.

Conclusion: Shorting crypto with caution

Shorting crypto is a powerful tool that offers traders the ability to profit in downturns and hedge their portfolios against risk. However, it requires advanced knowledge, strict discipline and a healthy respect for the unique dangers it presents. The combination of volatility, leverage and unlimited potential for loss makes shorting crypto a strategy in which mistakes can be punished severely.

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