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Short sellers get a bad rep (sometimes rightfully so).
But you don’t have to be a bear to go out hunting for shorts.
While everyone is in number-go-up mode, we’re donning our wizard robes and taking out our spell books.
Today we cover the dark art of short selling.
We’ll cover:
What is short selling (basics)
Where to short in crypto
Why you should short
How to find shorts
Risk management
But first. A warning before you proceed.
If you want to die broke, be a short seller
The most money is made on the long side. You are in crypto for the convexity. A good coin can 2x, 5x, 10x or more.
A good short might return 35-40%.
Still, crypto is an immature, inefficient, and at times irrational market.
There are good opportunities for the savvy investor to make short bets, either in isolation or as part of a portfolio hedging strategy (our preferred approach).
Not just that, but knowing which coins can become targets for short sellers at what points will make you better at managing your long positions. Are you picking up free pennies off the ground, or are you picking up pennies in front of a steam roller?
Short selling is an important tool in the toolbox if used appropriately in a risk managed way.
If you’re ready to peel back the onion and expand your knowledge of the dark arts, let’s dive in with a quick overview of the basics.
What Is Short Selling?
Short Selling, “shorting”, or “going short” is an attempt to profit from a decline in the price of a crypto token (or other asset). It can also be used to hedge a portfolio.
Basic process:
Borrow the target token (from Aave or other dApp or use a derivative instrument)
Sell the token to open the short position
Pay fees, monitor investment
Buy back the token to repay the loan or close the derivative
When you invest, buy a token, or “go long” you purchase a certain quantity.
When you “go short”, you borrow an asset then sell it at the market price.
Longs cannot lose more than the initial investment - you can’t be forced to sell below zero. This holds true even if you trade on margin. You buy first and have the option to hold or sell the investment.
Shorts, on the other hand, do not have that benefit. To close your trade you need to buy back the asset you originally sold to repay what you borrower. That means paying the market price at the time you close your trade.
If the market moved against you, closing your short could be expensive. For larger traders, it can also be difficult. You can ask Melvin Capital all about shorts that are expensive and difficult to close.
Alternative you would use a derivatives product. Both borrowing and derivatives facilities have costs. These costs usually accrue on a continuous basis for as long as your position is open.
Shorting is not a free lunch. Your upside is limited - since you can’t short a stock past zero you can only make 100% max. Your downside is unlimited in theory, since a stock you short can continue to rise becoming more and more expensive to cover.
Shorts allow you to express a negative view on an asset’s price. So why not use put options? As a practical matter most coins you want to short in crypto are not going to have puts available. Outside of BTC and ETH you won’t find a lot of put options.
Where to Short?
There are two ways to short tokens: spot borrow and derivatives, and each of them can either be done on-chain (Aave / dYdX) or off-chain (any major CEX).
We would suggest using a CEX to short. Just make sure not to overextend yourself or fall into a false sense of security by leaving large sums of money on CEXes. You’re only there for the trade.
Why not on-chain? You either take on counterparty / smart contract risk, or won’t be able to borrow many of the coins you would consider shorting.
For example, we generally consider Aave to be safe. Spreading risk is key but we’ve put a significant portion of our on-chain assets into their smart contracts in the past (farming stables, leveraging long ETH, etc).
The problem is that a lot of the tokens you’d want to short aren’t borrowable on Aave. That inevitably leads you to protocols which accept lower quality collateral or have weaker security. We’ll reference the Mango Markets exploit and leave it at that.
Basically, to short on-chain you’d need to overcollateralize (sometimes up to ~150%) the size of your short with a likely risky DeFi protocol.
A CEX will give you access to more opportunities but has its own risks - it is completely opaque and could default. There’s no perfect answer here but we prefer to use a CEX for shorts and manage our risk through position sizing, per the usual. Shorting perps on a CEX allows you to reduce counterparty risk by depositing only a fraction of your position value. Doing this increases your risk of liquidation so don’t over-leverage.
In summary: assume counterparty risk adds a few % per year risk of losing your entire capital invested in short sales, so don’t invest more than you can afford to lose. Similar to a risky degen bet on a promising altcoin.
Why Short Anyway?
Well that’s obvious.. to make money.
There are plenty of ways to make money though.
Why short?
You express your ideas through the various tools that markets provide. Shorting is one such tool available to you and other participants. To truly understand the complex world of financial / crypto markets, you will be well served at least knowing how to short.
Whether or not you should short at all, requires deeper exploration.
There are a few key reasons you short as part of a broader strategy:
Opportunity set: You’re active in crypto and it’s a crab market. You want to long strong tokens and short weak ones to make a decent return when you expect majors are likely to be flat.
Downside protection: You’re not very active but want some downside protection during times you think the market will go down or sideways. Rather than sell your core holdings (BTC and ETH) you short weak tokens.
You’re a short by nature: You’re particularly talented at spotting when a coin has reached an unsustainable valuation based on pure hype and want to be paid for contributing to market efficiency (perfectly valid service to provide)
Even if you don’t short, it’s important to know how shorts think because they are either already in your coins or standing in the periphery waiting for a chance to pounce.
If you learn which coins shorts will go after you can exit in a timely manner.
In the paid content that follows we cover the criteria you can use to find shorts, which just so happens to be the criteria shorts will look for when going after your coins. We also cover the most important things to avoid if shorting, when to close out your short and all the reasons you shouldn’t short.