Bitcoin (BTC) had an historic day recently… though not in the way you might think.
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The volume of short selling increased by 50 percent within a four-hour period. This was a big deal for the bitcoin market.
Short selling – or “shorting” – is when an investor borrows an asset in order to sell it. It’s a way to make money from a decline in the price of an asset.
Bitcoin is an exceptionally volatile asset… that is, its price moves fast and a lot. That’s great if it’s going up, and you’re long (that is, you own it). But it’s bad if you’re short (because you’re losing money as the price rises).
Over the past year, short interest in bitcoin has fluctuated from about 10,000-40,000 bitcoin.
On an average day, short sellers have borrowed about 20,000 bitcoin and shorted them. (That’s equivalent to around 0.1 percent of all bitcoin outstanding. A heavily shorted stock, on the other hand, might see 25 percent of its market capitalisation shorted. So bitcoin shorts are pretty small in relative terms.)
Two particular events concerning short sellers have caught my attention in recent months. The first was in January, and the last one was a few days ago.
Over the course of 36 hours on January 25 and 26 this year, short sellers borrowed and short sold 10,000 bitcoin in addition to those that were already sold short. The price of bitcoin was over US$11,700, which worked out to be an incremental total short position of around US$117 million.
Whoever these short sellers were… they got it right. Bitcoin prices plunged 40 percent over the following next weeks. Those 10,000 bitcoin sold short brought in a profit of over US$50million.
Then, just a few days ago – on September 2 – short interest increased by over 10,000 bitcoin again. But this time it all happened in less than four hours. I’ve looked at charts for a long time and have never seen a short interest graph that goes straight up like this, on what was otherwise a remarkably calm day.
Something big was happening. But what was it?
Assuming there wasn’t any funny business going on (more on that in a moment), this spike means one of two things. Either one really big investor made the bet of a lifetime, or a lot of large but not enormous investors all came to the same conclusion at the same time. And that conclusion was that bitcoin is ready to plunge again.
But what if I’m wrong and they’re right? I always ask that.
It’s possible the chart reflects an attempt by investors to sell short so much bitcoin in such a brief time frame so that they can drive the price down – and create a profitable trade for themselves. That would be a big risk – because it very well might not work – but it’s not impossible.
When the U.S. securities regulators rejected the applications of the exchange-traded funds (see this pdf), they specifically cited the concern that the bitcoin market could be victim of manipulation.
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That’s a possibility you face in the crypto markets (or really, any market) every day. This particular day is unusual because of how incredibly fast the short interest increased.
I watch bitcoin short interest because when it hits extremes, the market usually responds. It isn’t hard to see why aggressive investors would short a volatile asset like bitcoin. And usually, contrarian investing principles tells us that when short interest reaches an extreme, there’s a good chance a rally is coming… that is, if sentiment is so bad, the only direction a price can move is up. Admittedly, that’s not what happened in January. But it’s happened a few other times.
Short interest can be a contrarian indicator
Take April, for example. Bitcoin short interest had climbed for most of March and was at an all-time high of 39,000 bitcoin on April 11.
Soon after, there was a monster rally from US$6,850 on April 11 to US$9,950 on May 5 as the shorts had to cover their positions. This is called a short squeeze. When the bulls start buying and prices go up, short sellers start losing money and they are forced to buy back the bitcoin that they have borrowed and sold short.
That happened again in August. Short interest in bitcoin reached a new all-time high of 39,500 bitcoin. Short sellers were expecting the market to drop. But it didn’t. The price of BTC rose a little – costing the short sellers money – so the short sellers triggered a small rally as they scrambled to cover their short positions.
That’s a common scenario. But even after getting it wrong in August, short-selling speculators came back a week later – September 2 – and placed an US$80 million bet that the latest rally in bitcoin is over.
And the last few days have played out well for the short sellers, as bitcoin prices have dropped dramatically.
So, as a long-term bitcoin investor, what do I do when the short sellers are right and bitcoin sells off so dramatically?
As I’ve said before here, I believe we haven’t even begun to see the value of the transformation that decentralised ledger technologies such as bitcoin will bring to the world. I have my crypto portfolio properly allocated to what I am prepared to lose if I’m wrong. And, I follow one simple rule:
Keep some cash on hand.
You’d be smart to have more cash in your portfolio. Yes, it doesn’t pay much, its value erodes over time (due to inflation), and if you lose it (or put it through the washing machine), it’s gone forever.
But, over the short term – like the next year or so – the value of your cash stays constant (unless you live in Venezuela). And the value of your cash won’t change if markets crash.
Holding cash is one of the easiest ways to hedge your portfolio. Hedging helps reduce investment losses when your investment strategy doesn’t work out as planned.
Plus, having some cash on hand lets you take advantage of any great investment opportunities that may come up. It lets you pick up “money lying in the corner” – whether it’s cryptos or shares.
And as a long-term bitcoin investor, if the short sellers are right and the price of bitcoin plunges dramatically… to me, that will be like seeing money lying in the corner.
Crypto Analyst, Stansberry Churchouse Research