Profiting from Price Drops: Mastering Leverage Short DeFi Strategies

6 min readJun 14, 2024

🐻 Bearish on a token you’ve just discovered?

Factor’s Leverage strategies enable you to turn any token’s potential upside or downside into amplified profits with a single transaction.

There are two options when it comes to Leverage strategies : Long or Short.

Leverage Long (🐂/📈/🔼)

Taking a leveraged long position means borrowing funds to increase your exposure to an asset that you believe will increase in value.

The goal is to profit from the asset’s price appreciation. If the price of the asset increases, your returns are magnified due to the leveraged position.

Example: If you believe the price of BTC will rise, you might take a leveraged long position by borrowing funds to buy more BTC. If the price goes up, you benefit from the price increase on the larger amount of BTC you hold.

Leverage Short (🐻/📉/🔽)

In contrast, taking a leveraged short position means borrowing funds to sell an asset at the current price and repurchase it at a discounted price in the future as you believe it will decrease in value.

The goal is to profit from the asset’s price decline. If the price of the asset decreases, you can buy it back at the lower price, repay the debt denominated in the bearish token, and pocket the difference.

Example: If you believe the price of ETH will fall, you might take a leveraged short position by borrowing ETH and selling it at the current price. If the price drops, you buy back the same amount of ETH at a lower price, return it to the lender, and keep the profit from the price difference.

In this article, we will be going in-depth into how you can easily multiply the inverse of any % loss by the amount of leverage you select (i.e. a 10% price drop can result in a gain of more than 10%) with Factor’s Leverage Short Strategies.

*For an in-depth view into Leverage Long Strategies, click here.

Leveraging Short With Factor

Built to enable users to benefit regardless of the market conditions, Factor’s Short strategies also significantly increases your exposure to a token’s price depreciation resulting in more profits for the same initial capital. This is made possible through combining various DeFi building blocks:

Lending and borrowing from lending protocols (e.g. Silo, Aave, Compound, etc.)
Flash loans from Balancer
Instant swaps via aggregators (e.g. OpenOcean, etc.)

Strategy Explainer: Need an even deeper dive?
Decision Tree: Want to know if a Short strategy is right for you?
Performance Model: Want to understand how market movements will affect your position performance?
Strategy Simulations: Trying to find the optimal strategy parameters to maximize your gains?
User Guides: Want to get started with creating a leveraged position?

Why Go Short With Leverage?

Downside Speculation: By lending stable tokens (i.e. lending value remains unchanged) and borrowing the bearish tokens, the value of debt owed decreases if the bearish token price drops. The difference in the debt value at position creation and position close is realized as a profit due to the decreasing debt burden during the period of the loan.
Capital Efficiency: By incurring debt denominated in bearish tokens, you can then swap the bearish tokens for more stables and repeat the borrowing process. This means that you can sell bearish tokens worth multiple times your collateral value at a higher price and purchase the equivalent amount at a lower price when closing the position.
Additional Yields: Depending on the market conditions, lending pools sometimes pay significant Supply APYs (i.e. lending interest) for specific tokens. With leverage, you are supplying the whole leverage amount resulting in amplified lending yields.

What Are The Risks?

Liquidation: When taking out a loan, lending pools specify a liquidation threshold at which your position is liable to becoming force sold if the value of your collateral relative to debt drops below the threshold. This usually also incurs a liquidation fee hence always ensure that your position does not become under-collateralized.
Borrow Costs: Depending on the token borrowed, lending pools also charge a Borrow APY (i.e. borrow interest) on the position’s debt amount. Only open a Short position if you believe the token downside is greater than the borrowing costs incurred [(leverage multiplier — 1) x Borrow APY].
Non-linear Losses: The multiplier effect for Shorts also occurs in the opposite direction as your debt burden increases according to the total bearish tokens owed in the case whereby the market moves opposite to what you expected.

How Does Leverage Turn Losses Into Profits?

Lending Stables And Borrowing Bearish Token

At the core of every Short strategy, you are effectively:

Lending the token whose value is stable relative to the lending token (i.e. stablecoins or base tokens)
Borrowing a token that you’re bearish on and swapping it for more stables
Buying back the discounted bearish tokens when closing the position

As the debt is denominated in bearish tokens, you will just have to repay the equivalent amount (not value) of bearish tokens when closing the position. Any decreases in the debt token price means that you can repurchase the bearish tokens at a discount in order to repay the loan.

Price goes down, collateral remains the same, debt burden decreases, the difference in price is realized as profits.

Adding (Even More) Leverage

As the bearish tokens are swapped for more stable lending tokens, you can add even more leverage by lending it back to the lending pool, borrowing more debt tokens, and swapping the bearish tokens for more stables.

By looping through this cycle with decreasing amounts of debt, the position effectively “sells” more bearish tokens at a higher price and locks in the initial debt value in stables. The loan only needs to be repaid when it is closed hence you are able to purchase the debt amount at a discounted value in the future if the price drops.

Note that the availability of interest-free flash loans from Balancer enables the above process to be simplified significantly.

Putting It Together

When opening a Leverage Short position, the key conditions to pay attention to are:

Short Strategy Breakeven Point (A): Interest is accrued when tokens are lent or borrowed from a lending pool. Your position incurs a borrowing cost if the interest on debt is greater than the interest earned on your collateral. This means that Short positions only become profitable when the bearish token price decrease is sufficient to justify any borrowing costs.
Short Strategy Outperformance Vs Hold Strategy (B): Due to any borrowing costs incurred, there is a point up to which a basic hold strategy will outperform a Short strategy. The Short strategy will be a better option only if the profits from purchasing discounted bearish tokens outweighs the value of the hold strategy plus borrow costs.

The chart below highlights the above two points conceptually:

Aside from the Short strategy mirroring the price direction, notice that the more leverage taken, the steeper the gradient which results in a higher multiplier. This also applies in the other direction as can be seen in the bottom right quadrant.

Conclusion

By combining various DeFi primitives, Leverage Short strategies enable you to realize a profit when the debt token (i.e. bearish token) depreciates in value. It is a boosted wager that magnifies both the potential gains if the market agrees that the debt token is overvalued and potential losses if the market agrees that the debt token is undervalued. As such, it is an extremely powerful trading tool that can be easily accessed via the Factor dapp.

At Factor, we are making complex DeFi strategies more accessible and efficient for the average user. Please visit our Docs if you would like to discover a world of infinitely composable and permissionless DeFi strategies.

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