It’s no secret that crypto trading can be a risky investment. Market downturns are inevitable. As a trader, you need to find ways to protect your investment from risk, and this is where crypto hedging strategies come in. Hedging encompasses opening positions in opposing market directions to reduce the risks and impacts of market swings.
But what is a hedging strategy? What are cryptocurrency risks? How to apply risk hedging strategies to crypto? Is hedging 100% risk-free? If these questions seem perplexing, you’ve come to the right place. This article will explore everything you need to know about hedging. In addition, we’ll show you four crypto hedging strategies you can easily apply.
In fact, the introduction of crypto hedging has tamed the crypto bubble in 2018.
Let’s dig in.
What is a Hedging Strategy?
According to Investopedia, a hedge is an investment that is made to reduce the risk of adverse price movements in an asset. Hedging strategies enable traders to use more than one concurrent bet in opposite directions to minimize the risk of drastic losses.
Hedging has long been a financial market strategy as a form of risk management technique for crypto traders. It allows you to maintain a stable value for your investments (without making a considerable return) in undesirable market conditions.
While hedging crypto protects your assets from adverse market changes, it also limits the potential gains you get from your crypto investment. However, for risk-averse crypto traders, this is a better option than losing all their assets due to an adverse price fluctuation in the cryptocurrency market.
Types of Cryptocurrency Risks
Much like the forex market, the cryptocurrency market possesses similar forms of risks: volatility risks, regulatory risks, transactional risks, and leverage risks.
Cryptocurrency risks (just like most financial instruments) generally emanate from the volatile nature of these currencies. Trading in crypto is mainly speculative. Therefore, you must understand these risks before you start trading.
Cryptocurrencies are Volatile
Since cryptocurrencies are highly volatile, sharp and sudden price movements often occur as market sentiments change. It is common for the value of cryptocurrencies to quickly swing, by hundreds or even thousands of dollars at a time.
In January 2021, Dogecoin is a decentralized cryptocurrency with a very large community. The name “Doge” originates from internet mem... increased by more than 800% in 24 hours and the price dropped by more than 500% the next day.
They are unregulated
Neither governments nor central banks regulate cryptocurrencies. While governments and financial institutions are starting to take note, there’s still uncertainty about issues such as whether to classify them as a commodity or a virtual currency.
The lack of regulations limits the protection of sellers and buyers, leaving investors to rely on developments, individuals, and personal experience when making investment decisions.
Errors in communications and delay in transacting the traders’ orders may result in huge losses for crypto traders. Therefore, it is vital to choose an exchange that can handle a large volume of Transactions per second (TPS) is the number of transactions a blockchain network can process each second or the number o... (TPS). For instance, Bybit is leading the crypto industry by processing up to 100,000 TPS/ It also provides methods of recourse for crypto traders.
With low margin deposits and collateral, traders can enjoy a high degree of leverage. Traders need to be cautious about using aggressive leverage that can increase losses during unfavorable conditions.
Now that we have covered the downside risks of cryptocurrency, let’s dive into hedging cryptocurrency risks.
Golden Rules for Hedging
If you are overly worried about the risk to your position, closing it entirely or reducing its size is a safer option. But hedging can be a helpful strategy if you want to maintain your crypto holding and create a neutral exposure. Here are some of the principles you should bear in mind before applying hedging strategies:
- Opposite position: The rule is simple. A trader ought to enter a position that is the opposite of its current position. For instance, if you forecast an increase in a cryptocurrency’s price, you should enter a long position.
- Liquidity assessment: Traders and investors look closely into a new asset’s liquidity to determine market integrity, transaction speed and market fluidity, in order to allow traders to exchange their assets for cash quickly without too much price slippage.
- Diversification: It is an open secret that diversification is one of the best money management techniques available for traders and investors. You can open multiple positions in Bitcoin(BTC), Ethereum(ETH), Chainlink (LINK), and many other tokens to create a well-diversified portfolio made up of derivatives.
Types of Hedging Strategies
You can deploy crypto hedging strategies in a variety of ways. Here are the four most popular methods.
1. Short Selling
Short selling means taking a position to sell an asset when the trader believes that an investment will fall in value. You as a trader can look forward to making a profit by buying back at a lower price — or profiting from the difference. Short selling in cryptocurrencies protects against long exposure.
According to Investopedia, short selling allows investors to hedge against the downside risk of a long position in the same security, or a related one.
Shorting typically adds complexity to crypto. Therefore, be careful with this tactic, whether you are shorting crypto for hedging or speculation. You can short cryptocurrencies in different ways, including:
- Margin trading, in which you can borrow from a broker to make a trade. Exchanges that allow margin trading also offer leverage, which can increase potential profits or losses.
- Traditional short selling, where you borrow from a broker, credit platform or third party, and then sell the crypto and repurchase it at a better price.
Downsides of Shorting
The potential for loss is infinite when short selling. You can long for a cryptocurrency that may swing to the price of $0, resulting in a complete loss. So in order to avoid disastrous losses, a trader will set a stop-loss limit at his initial investment.
In finance, the term futures refer to an agreement to sell or buy an asset on a specific future date at a certain price. As it has a secondary market of its own, the futures can be sold before the agreed upon date. This increases liquidity of investors and business owners. Futures contracts are part of a large category trading instruments known as derivatives, including Contracts for Difference (CFDs), Options, and Swaps.
Cryptocurrency futures operate under a similar concept. Due to the volatility of cryptocurrencies, most traders buy when the prices are low and sell when the prices are high. However, such selling and buying can cause investors to miss potential profits.
Cryptocurrency futures allow you to leave your position open, thus maximizing the profits to be gained from your crypto investments. Today, CME provides several Bitcoin futures with different expiration dates, for example in its Bitcoin Futures Calendar. All contracts are settled in U.S. dollars at the date of expiration.
Futures contracts hedge your investments or lock your profits in a volatile market such as cryptocurrency. They are ideal for investors who want to hedge their exposure in the crypto market for a reasonable period.
Benefits of futures are:
- Mitigating the risk of falling prices by taking a short future position, and benefiting from increasing prices by taking a long future position
- Futures allow you to speculate on market direction
- Futures help smooth your exposure and stabilize price fluctuations
The risks of hedging through futures include leverage risks, as discussed above. However, leverage risks remain one of the popular options for crypto hedging.
3. Perpetual Swaps
Perpetual swaps are derivatives that allow you to buy or sell the value of an underlying asset without setting an expiration date for the position you take (you can choose when to take or exit a position at any time).
Perpetual swaps offer you more buying power than you would have when spot trading. Thus, they place you in a better position to take advantage of price fluctuations. Perpetual swaps operate under a funding rate mechanism in which you pay a fee or rebate to continue holding your position.
Before using perpetual swaps as a hedging strategy, you need to determine your collateral’s funding rate mechanism and potential returns. You also need to understand the leverage the exchange you choose allows (derivatives can allow up to 100x leverage).
This strategy has quickly gained notoriety in the crypto market. It enables traders to leverage on positions without an expiration date. The key difference is that a perpetual swap is traded close to the index price of the underlying asset.
The perpetual swap also charges funding rates. This incentivizes traders to buy perpetual swaps when the index price is bullish. The funding rates are usually designed to ensure price stability.
Since they do not rely on an expiration date, perpetual contracts quickly took off on BitMEX. They are soon to be adopted by major crypto exchanges, including Bybit and Binance.
Perpetual swaps as a hedging strategy have its advantage:
- They offer greater liquidity, thus making it easier for more traders to participate
- The higher leverage provided means you can earn more with less
- They are ideal for short-term hedges
However, due to the fluctuations in the funding rate, a perpetual swap can make the hedging cost unpredictable. The losses from high leverage rates could be greater as well.
Options are another type of derivative in crypto. They allow investors the right — but not the obligation — to buy or sell an underlying asset at a specific price, or before a certain date. You can use options as a way to hedge cryptocurrency by limiting downward losses in a declining market.
Put options increase in value when the underlying asset declines below the exercise price of the option, while call options will decrease. This results in a significant level of leveraged hedge protection at a relatively lower cost.
You can also use options for speculation on the direction of a cryptocurrency. Options come as call options or put options. A call option gives you the right to buy a stock, while a put option allows you the right to sell a stock.
Advantages of hedging cryptocurrency risks with options include:
- Limited downside, with an unlimited upside
- More predictability
Disadvantages of options
The major downside to using options is the expiration date. Long-term options can be pricey, while a short-term option may result in options expiring before they can provide you with the desired hedging protection.
Is Hedging 100% Risk-Free?
Hedging is not 100% risk-free. While investors use hedging to protect themselves from fluctuations in the market, hedging also comes with its risks. It does not guarantee the success of your investment. Neither does it ensure that your investments mitigate the risks.
When choosing a crypto hedging strategy, the best approach is to consider the advantages and disadvantages of hedging a particular crypto asset. You should also determine whether the benefits of the hedging strategy you choose outweigh the expense that comes with the hedge.
In some cases, hedging can be counterproductive, especially when the market remains neutral (you still have to pay the hedging costs).
The Bottom Line
Cryptocurrencies are indeed volatile financial instruments that come with certain risks for investors. Crypto traders should be aware of financial strategies, such as hedging, that minimize potential loss and protect their position, regardless of the market conditions.
Hedging protects you from huge losses that could be experienced in the highly volatile cryptocurrency market. Another reason why hedging crypto is essential is that it protects your profits in the event of a crash or price correction.