A market is ultimately defined by buyers and sellers of a good or service. In the context of modern finance and exchange platforms, having buyers and sellers making a market on either side of a tradeable asset is an instrumental aspect of liquidity. The ability to short assets, or effectively borrow an asset to sell and buy back later at a lower price, is considered a vital tool of the price discovery process. With the cryptocurrency market gradually evolving and gaining more widespread recognition, this feature has been added to certain exchanges, improving liquidity in an immature marketplace that often suffers from the sudden disappearance of bids and offers.

However, just because the rapid rise of cryptocurrencies makes certain short theses particularly juicy, it does not necessarily imply that shorting these instruments is without risk. One specific currency that has recently found itself square in the crosshairs of speculators is Ripple. Originally intended as a useful tool for financial institutions to conduct cross-border transactions at substantially reduced costs, Ripple is at the heart of a rapid rally being experienced in alt-coins as investors diversify their holdings. Despite its attractive degree of practicality and functionality, it does not necessarily mean that Ripple is destined to continue climbing in value unabated. Nevertheless, taking short positions, while potentially beneficial at opportune times, might not always be a sound strategy.

Unleashing the Shorts

As more exchanges add a greater number of cryptocurrencies to their rosters of tradeable assets and crosses against other coins, the opportunity to short what many perceive as a bubble or mania has risen in popularity. In Ripple’s case, there are several attractive reasons for potentially taking a more bearish stance on XRP, namely due to its use as a centralized infrastructure solution. While some believe that its centralization is a detriment, suggesting the possibility of manipulation, one of its existing attributes could theoretically be advantageous for traders eying short positions.

A reason Ripple stands out relative to other coins is that XRP is not mined like other cryptocurrencies, and not all XRP minted is currently in circulation. In fact, 55 billion XRP were originally locked in smart contracts, with 1 billion being released on the first day of each month. From a supply and demand perspective, adding supply could theoretically drive prices lower, helping bolster short theses.

However, despite additional supply coming online, foremost amongst the reasons against shorting XRP is the deflationary nature of a finite asset that is gradually shrinking in volume over time. A distinctive characteristic of Ripple relative to other coins is that each time XRP is used to transact, a small portion of each coin is destroyed or “burned.” This means that over time, despite incoming supply which is capped, the total amount of XRP circulation is destined to fall, with exact timelines dependent on how frequently Ripple is used to transact.

"The future looks pretty bright for Ripple Labs as a company, but the XRP tokens that people are currently trading on is a different thing altogether," says Mati Greenspan from etoro, a social investment network that supports XRP investments. "Many people are mistakenly treating XRP as if it were an equity share in Ripple Labs, which couldn't be further from reality. The XRP tokens we're created in order to pay for transactions on Ripple's main blockchain."

Greenspan continued: "If you transfer $1 million from Bank A to Bank B, a small amount of XRP is burned as payment for the transfer. However, many new partnerships that Ripple is forging without utilizing the main blockchain or the XRP tokens. Overall, the economics of this unique token are super-deflationary. Meaning, as more XRPs are burned the supply goes down and the price goes up, but since they started out with a whopping 100 billion tokens, it could take a while to burn through them."

Is Unlimited Risk Worth the Reward?

At present, there are a few ways to short Ripple, either by shorting pairs where XRP is the base currency or going long pairs where XRP is quote currency. However, the risks of such a play are substantial for several reasons. One of the basic issues with shorting a currency is that the upside in such a trade is limited. Short positions are inherently a bet that the price of an instrument is headed to zero. Prices cannot go negative, so the reward side of the risk-reward equation is ultimately fixed at the distance from current prices to zero. By comparison, the risk of unlimited loss is a possibility when taking a short position, creating a disincentive in a potentially volatile marketplace whereby Ripple can move by double-digit percentage rates in a single session. (See also: Ripple Is Back: Here's Why.)

Apart from the rather obvious risk-reward tradeoff of a short position, the potential for short squeezes should give traders pause, especially in such a young market where thousands of new participants are streaming in every day. Furthermore, ongoing efforts by many early cryptocurrency adopters to diversify their holdings may be a development that helps prop up prices. While short-term opportunities to take short positions may be very attractive, the long-term short case is very thin.

Although speculation has driven recent gains, making for an attractive short setup, ultimately, if Ripple is a successful solution, it could garner more upside momentum as the velocity of XRP spending accelerates. The strong use case combined with adoption by some of the globe’s largest financial institutions means that already its usefulness vastly exceeds that of some of its prominent competition like bitcoin and Ethereum. Nevertheless, despite its usefulness relative to other coins which are more sluggish and facing scaling issues, Ripple’s latest run may have been overextended, presenting a unique prospect for aggressive traders unafraid of taking substantial risks.

Spitting Into the Wind

While the prospect of shorting an instrument rapidly rising in value may be attractive to some traders and speculators, it is not without substantial risks. For an intra-day trader, the rewards can be enormous, as evidenced by the steep downturn following CoinMarketCap’s move to change how it measured aggregate prices for XRP. However, the attractiveness of the rewards should not negate the inherent risks of unlimited potential loss. In addition, should liquidity disappear, exiting from a short position may prove difficult, adding to concerns that a short squeeze could cause a trader to go completely bust.

After returning over 35,000% in 2017, it is no wonder that traders are salivating over the prospect of shorting XRP. But caution is advised alongside a very abbreviated trading time horizon. With the astounding amount of daily volatility present, shorting carries notable risks. Furthermore, on a long-term basis, shorting a deflationary asset is highly inadvisable, especially for Ripple, which is seeing a portion of each coin being destroyed after each transaction, shrinking the supply over time.

While the long-term case is the equivalent of spitting into the wind, opportunistic day traders with a penchant for risk-taking may well be rewarded for their discipline if trades are well planned and executed. Ultimately, the question of “to short, or not to short” Ripple comes down to investors’ preferred trading time horizon.

Investing in cryptocurrencies and other Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.