To In the world of decentralized finance (DeFi), margin trading has emerged as a popular strategy, allowing us to amplify our exposure and do more with our capital. One of the techniques we can employ in this realm is "shorting." In this guide, we'll delve deep into the concept of shorting within DeFi, where cryptocurrency assets are borrowed from lending protocols rather than traditional stocks from brokers.

What is Shorting in DeFi?

Shorting, in the context of DeFi, is a strategy where we borrow cryptocurrency assets from a lending protocol and sell them in the open market. Our intention is to later buy them back at a lower price, profiting from the anticipated decline in the asset's value.

This can be a very useful tool, particularly when navigating a bear market where most crypto assets have declining prices. This tool can also be used for pure speculation.

How Do We Execute Shorting in DeFi Margin Trading

Initiating a Short Position: To start, we borrow the crypto assets from a lending protocol. This can be done through 1delta which automatically borrows funds from lending protocols. These lending protocols require us to provide collateral to secure the borrowed assets which also can be done through 1delta.

Selling the Borrowed Assets: After borrowing, we sell the assets in the open market at the current price. With the proceeds of the sale, we will have to later buy back the assets we borrowed. We can further adjust our market exposure by selecting a specific asset. In most cases, it’s recommended to hold a stable asset.

Closing the Short Position: At a later time, we aim to buy back the assets, ideally at a price lower than what we sold them for. Once repurchased, these assets are returned to the lending protocol, and we pocket the difference as profit.

Liquidation Risk: In DeFi, if the value of our collateral drops below a certain threshold due to the asset's price rising, our position might be at risk of liquidation. In such cases, the protocol can sell our collateral to cover the borrowed amount.

Risks

Shorting in DeFi, while potentially lucrative, comes with its set of risks. 

Profit & Loss

The potential loss when shorting is theoretically unlimited since a crypto asset's price can rise indefinitely. Conversely, our potential profit is capped at the price at which we initially sold the asset, given that its price can't drop below zero.

In DeFi, users can’t lose more than they initially invested, as the positions get automatically liquidated and in case the protocol turns a loss, this debt is not transferred to the borrower.

Short Squeeze: This happens when many traders try to close their short positions simultaneously due to a rapid price increase, pushing the price up even more, leading to potential losses for those holding short positions.

Collateral Volatility: The collateral you provide can be subject to high volatility, especially if it's in cryptocurrency. This can lead to unexpected liquidations if the collateral's value drops suddenly.

Smart Contract Vulnerabilities: DeFi operates on smart contracts. If there's a bug or vulnerability in the smart contract of the lending protocol, it could lead to significant losses.

Protocol Insolvency: If too many traders on a platform face liquidation and the protocol can't cover the losses, it might lead to insolvency, affecting all users.

Gas Fees: On platforms like Ethereum, high gas fees can eat into profits, especially during times of network congestion. This can be particularly problematic if you need to close a position quickly.

Example

To show you how you can short assets using the 1delta platform, we walk you step by step through an example. 

For our example, we want to short WMATIC, because we believe that the many L2s offering new blockspace are taking away market share from Polygon.

Prerequisites:

• Connect wallet
• Select lender and network: Aave on Polygon
• Have 10 USDC in a wallet on Polygon mainnet

1. Deposit collateral

To make a deposit, we first click on Deposit on the Wallet or Positions table:

We choose 10 USDC from our wallet and also choose USDC as the asset we want to deposit:

We finally confirm the deposit and approve the transaction in our wallet:

2. Open short position

After we have deposited our collateral, we open our short position. For this, we select the asset we want to short at the top, in our case 30 WMATIC. 

At the bottom, we choose USDC, as we want to hold a stable asset until we buy back the WMATIC. Here you could choose any asset, which is changing your market exposure, as you will sell this asset to buy back the WMATIC.

We first need to approve Allow borrowing WMATIC and then Build Position:

By clicking on Confirm Trade we initiate the transaction which has to be approved by our wallet:

3. Reviewing the position

Finally, we can see our short position in the Positions table:

Our Positions table shows the 30 WMATIC which we borrowed and sold for USDC. The USDC position contains our initial 10 USDC deposit plus the proceeds from selling the 30 WMATIC.

The position table also shows the interest rates on our positions. We are paying 5.804% per year to borrow $15.69 worth of WMATIC. On the other hand, we earn positive interest of 2.841% on $25.69 worth of USDC. This means our cost of maintaining this position is about 1.15% p.a. with respect to the $15.69 short position in WMATIC.

Conclusion

Shorting in DeFi margin trading offers us the opportunity to capitalize on declining asset prices. However, it's crucial for us to be well-informed about the market dynamics and risks involved. As always, thorough research and sound risk management practices are our best allies when navigating the DeFi landscape.

If you want to try this for yourself, head over to the 1delta app or consult the community for further support.