What is Hedging?
Hedging is a method of mitigating potential investment losses by entering a position expected to perform in the opposite direction of an existing position.
For example, a trader who is long bitcoin but wants protection against a potential short-term market downturn can use derivative trading instruments that will yield a profit if the value of their bitcoin falls.
Hedging can be useful by anyone seeking to moderate their exposure to the crypto market’s volatility.
How to Hedge Cryptocurrency
Hedging techniques generally involve the use of financial instruments known as derivatives.
These are contracts between two parties that track the price of an underlying asset. Derivatives allow investors to gain exposure to the price movements of an asset without having to own the asset itself.
For cryptocurrency investors, this indirect exposure can be especially valuable as it eliminates the need for a secure custody solution. Because hedging derivatives are simply contracts between two parties that yield a return based on the price movement of an underlying asset, neither party ever needs to actually own the asset in question. From initial trade to final settlement, no actual cryptoasset is bought or sold.
The two most common derivatives used to hedge crypto trading positions are futures and options. Both allow investors to go long and profit when an underlying asset goes up in price or to go short and profit when it declines. They generally represent the right to buy or sell a specific asset at a specific price on a specific future date.
When trading crypto options contracts, an investor can either buy calls (the future right to buy an asset at a specific price) or puts (the future right to sell an asset at a specific price). When done to protect an initial investment from downside volatility, this is called “hedging.”
To purchase an options contract, a trader must pay a premium in order to gain this exercisable right. Options premiums ensure options sellers are compensated, since the purchaser does not have the obligation to buy or sell a particular asset if the option ends up unprofitable, also known as out of the money (OTM).
Examples of Hedging Strategies
Suppose an investor owns an amount of ether (ETH) – the native cryptocurrency of Ethereum.
Although they believe in the long-term prospects of the project, they are worried about short-term development issues that might negatively impact the price of ETH. To protect their investment, they can buy an ETH put option, which gives them the right, but not the obligation, to sell ETH at a specific price (also known as the strike price) on a certain future date.
If the price of ETH falls below the strike price, the investor can exercise the option and sell ETH at the higher strike price, offsetting their portfolio losses.
Futures contracts are agreements to purchase or sell a specific asset at a specific price on a specific future date – known as the contract settlement date.
The settlement takes place regardless of the asset’s price, meaning if one party agrees to sell one bitcoin at $40,000 and BTC’s market price on the day of settlement is $30,000, they will be forced to make the sale – resulting in a $10,000 loss.
Suppose that a bitcoin investor is worried about an upcoming announcement from the Chairman of the Federal Reserve and believes it could adversely affect crypto market sentiment.
To protect against the uncertainty of the Federal Reserve Chairman’s statement, the investor can enter into a futures contract agreement and short bitcoin (meaning they profit when the price of bitcoin falls). If the investor is right and bitcoin’s price does tumble following the Fed announcement, their futures contract short position will be profitable.
Perpetual swap contracts, or “perps,” are similar to futures in many ways. The primary difference is that instead of having a predetermined future settlement date, they can continuously be rolled over, providing a trader with a method of hedging that does not have a predetermined future date when it will end.
To ensure a perp contract tracks the price of its underlying asset, a funding rate mechanism is employed whereby long and short traders pay fees to one another depending on whether the perp contract price is above or below the market spot price at a given time.
For example, if there is larger volume demand for long bitcoin perps than short bitcoin perps in the current market, the contract price will trade above the current spot market price of bitcoin. To dissuade new long traders from entering the market and increasing this price discrepancy, the funding rate system will require long traders to pay a fee to short traders at fixed intervals based on the size of their open positions.
In this scenario, short traders would receive a steady percentage return from fees paid by long traders until the contract price returned to bitcoin’s spot market price.
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Summary of Hedging
- Hedging in crypto is a trading strategy used to mitigate the downside risk of existing portfolio positions.
- Hedging predominantly involves the use of derivatives (such as options and futures contracts) to offset potential losses in a specific cryptoasset holding. This is achieved by opening a trade that will perform in the opposite direction of an existing position.
- Hedging can help protect against negative price movements in a spot cryptoasset position without having to sell it.