Utility of Borrowing - Shorting
Setting the Scene
Picture this - you are a budding young trader following Tztokchad’s masterclass on market indicators. Elliot waves. Pythagoras. Support and Resistance. A foreign language to some but for you a powerful tool to predict future price action.
You glimpse this chart. The signs are all there. Bitcoin is going to zero.
Whatever tactics you used to determine that $BTC’s price would decline, as a trader you want to turn this conviction into a profit. But without holding any $BTC, how are you able to do this?
Shorting in General
Shorting is a trading strategy where you are speculating on the price of an asset to decline in the future in order to turn a profit.
In its most basic form, a trader will put up assets as collateral on a lending market to borrow another asset that they believe is going to decline in value. They will then sell it on the open market and repurchase the asset after the price has fallen. They can then repay their borrowing and keep the difference between the initial sale price and final purchase price.
There are 4 requirements for a short position to be established:
The asset you wish to short
The asset you use to borrow (collateral)
Lending market: this is required to borrow the asset you wish to short
Trading market: this is required to sell the asset you wish to short
Shorting on Silo Finance
Silo is a secure, permission-less, and efficient lending market that allows you to borrow any token using any other token as collateral. As a lending market, shorting is naturally amongst one of its many capabilities.
Using the above chart as an example, pretend that you are a trader who believes the price of $BTC will decline relative to $USD value. Let us also assume that $USDs (Silo’s stablecoin) has a collateral ratio and liquidation threshold of 80% and 1 $wBTC (wrapped $BTC tradable on Ethereum) is $40k.
Creating a BTC/USD short position on Silo would involve:
Deposit 80000 $USDs into the wBTC silo and borrow 1 $wBTC (keeping a health LTV of 50% to minimize liquidation risk)
Sell 1 $wBTC on an exchange and receive $40,000
After 4 weeks, the price of 1 $wBTC has declined to $30,000 and you repurchase 1 $wBTC
You repay your 1 $wBTC loan to the wBTC Silo and withdraw your $USDs collateral
As a gigabrain trader, you profit the $10k difference in $wBTC price
Assessment of Risks
In an ideal scenario where $wBTC moves downwards as expected, a short-seller can make a tidy profit. However, predicting prices is a fallible thing and price action may not always meet your expectations - here are some risks that you should carefully consider:
1. Closing your short
In the previous scenario, if the price of 1 $wBTC moves to $50,000 (rather than down to $30,000 as expected), they would only be able to purchase 0.8 $wBTC (40,000/50,000 = 0.8) with their proceeds from their original sale. They would need to purchase an additional 0.2 $wBTC from additional funds to close their short - a loss of $10,000 (0.2 * 50,000 = 10,000).
Further to the costs involved with closing your short, if the value of the borrowed asset continues to increase the short-seller runs the risk of liquidation. This means that the borrower’s underlying collateral ($USDs) may be sold to liquidators to ensure $wBTC lenders are made whole. Often this will also involve payment of a liquidation penalty.
More on liquidations will be discussed in a future article.
3. Borrowing Costs
One cost that has been neglected is the cost of borrowing. As a short-seller you are functionally borrowing the asset that you are shorting which means you must pay interest to the party you are borrowing from. This interest will constantly accrue to your outstanding loan amount and should be considered when building a short position.
Alright, that's enough educational material for the day.
Back to sweeping the floors.