If you are a crypto trader looking to manage risk and protect your investments in the highly volatile market, follow these steps to implement effective crypto hedging strategies:
Summary
- Hedging is a risk management practice in the cryptocurrency market to protect against adverse events.
- The cryptocurrency market is known for high volatility, presenting both profit opportunities and risks.
- Diversifying the portfolio with multiple crypto assets can help reduce overall volatility and losses.
- Using options, futures, and perpetual swaps are effective hedging strategies.
- Hedging with futures involves trading specific crypto assets at predetermined prices on specified future dates.
- Perpetual swaps offer continuous trading without expiration dates and incorporate a funding rate mechanism for price alignment.
- Traders must understand the risks and rewards of each hedging method and exercise caution with leverage.
What is Hedging?
Hedging is the practice of taking a position in an asset that is the opposite of the currently open one. Traders view it as a type of insurance that shields them from the effects of an adverse event.
The cryptocurrency market is known for its high volatility, characterized by rapid and dramatic price fluctuations that can surge and plummet swiftly. While this volatility presents profit opportunities, it also exposes traders to considerable risks. To effectively manage this risk, traders utilize hedging.
For instance, let’s consider a trader currently holding a profitable Bitcoin (BTC) position. However, the trader anticipates a forthcoming price drop in Bitcoin and decides to hedge the asset. Hedging, in this context, involves opening a second position that opposes the initial profitable one, aiming to safeguard the positive unrealized profits.
As market conditions shift, the initially profitable position might turn negative. In contrast, the secondary position established during hedging will generate profits, offsetting a portion of the losses incurred in the first position.
How to Hedge Bitcoin in Cryptocurrency trading
Portfolio diversification
Diversifying your cryptocurrency portfolio is a highly effective long-term strategy for crypto hedging. It involves investing in multiple crypto assets instead of putting all your funds into just one.
The diverse portfolio strategy operates on assets that move independently. As a result, holding uncorrelated assets that have a negative delta correlation to your current exposure helps decrease overall volatility. Simply put, Diversification involves investing in various crypto assets instead of putting all funds into a single cryptocurrency.
In a diversified portfolio, each asset serves as a hedge against others. Consequently, when the price of one asset decreases, the overall loss is reduced compared to investing all funds in a single asset.
Ideally, traders should invest in unrelated or non-correlated assets. In the context of a crypto-only portfolio, Diversification can be as straightforward as holding a mix of large-cap coins like Bitcoin (BTC) and Ethereum (ETH), along with some altcoins. The large caps help offset the higher risks associated with altcoins, while the altcoins offer the potential for greater gains.
Using Hedging mode trading
Hedging, a widely used risk management technique in traditional financial markets, involves buying or selling assets to mitigate the risk of loss in an existing position or adverse price fluctuations.
While crypto hedging safeguards your investment from unfavorable market swings, it limits potential gains from your crypto investment. However, this trade-off is preferable to experiencing significant losses in your investment.
Various methods exist for hedging your crypto portfolio, such as dollar cost averaging, buying options, futures, and yield farming.
In hedge mode trading, the risk of liquidation is significantly reduced through the following steps:
- 1. A trader opens two opposing positions.
- 2. As the price moves in one direction, the other (losing) position offsets the crypto margin in the profit and loss (P&L) for that contract.
- 3. Simultaneously, the winning position contributes unrealized gains to the shared P&L.
- 4. This approach allows the trader to maintain a long position for the long term while simultaneously placing multiple short positions to profit from short-term downward moves.
Hedge mode trading is particularly suitable for intermediate to advanced traders who:
- 1. Aim to generate short-term profits while holding an opposing long-term position.
- 2. Seek to capitalize on opportunities when the market rebounds.
- 3. Institutional investors who wish to hedge their positions for a specific contract with shared P&L.
Hedging with Options
The cryptocurrency space is relatively new and offers limited options, with Deribit and Bitmex being the pioneering exchanges supporting it. Investors have the option, but not the obligation, to sell or buy a specific asset at a predetermined price and date.
In the realm of option contracts, there are two types: “call options” and “put options.” A call option grants the right to purchase a cryptocurrency, while a put option grants the right to sell a cryptocurrency at a predetermined price on or before a specific date.
By acquiring a put option, investors can hedge against potential losses caused by market fluctuations. For instance, if Bitcoin’s price declines, the investor can exercise their option to sell the asset at the predetermined price, thus safeguarding themselves from losses due to the asset’s devaluation.
Alternatively, traders can employ call options to speculate on the upside potential of a specific cryptocurrency. By purchasing call option contracts, investors bet the asset’s price will increase by a predetermined amount by a specified date. If their prediction proves correct, they have the potential to earn a profit from their investment. Utilizing options for hedging is an effective way to minimize losses and increase profits when trading cryptocurrencies.
Hedging with futures
A futures contract is a financial arrangement between two or more parties agreeing to trade a specific cryptocurrency asset at a predetermined price on a specified future date. The futures contract offers the advantage of having a secondary market, allowing traders to sell it before the designated date.
This cryptocurrency futures contract allows traders to hedge against potential price declines by initiating a ‘short position’ when they anticipate a pullback. In the secondary markets, they can open a short position, generate capital, and reinvest when the price decreases.
Conversely, traders benefit from cryptocurrency futures when prices increase, enabling them to take a long position with a futures contract. These futures contracts allow traders to keep their positions open, providing greater flexibility to maximize profits. For instance, if a trader holds 1 BTC, valued at $60,000, and aims to secure this price, they would require 60,000 contracts, with each contract representing $1 worth of BTC at the specified price.
Nevertheless, when the price rises, the trader would face a loss by repurchasing the futures at a higher price. Conversely, if the trader adopts a long position and retains the contracts, they would realize gains when the price increases and suffer losses when it declines.
When traders employ substantial leverage in futures trading, their potential profits can be amplified. However, it’s crucial to recognize that the resulting losses will also be magnified during unfavorable conditions. As such, traders must exercise caution and be mindful of the risks of using leverage in futures trading.
Perpetual Swaps
Perpetual swaps, also known as perpetuals, have recently gained popularity as more crypto exchanges begin to offer them. The main reasons for using this financial instrument are similar to those for futures contracts.
Perpetual swaps are derivative products that enable the buying or selling of the value of an underlying asset without setting an expiration date for the position taken.
By using perpetual swaps, traders gain “increased buying power” compared to trading in the spot market, which puts them in a better position to profit if the price moves favorably.
Perpetual swaps incorporate a funding rate mechanism to ensure that their price remains relatively close to the underlying asset’s price. Due to this continuous realignment with the spot price, these contracts are favored as a hedging strategy.
Before utilizing perpetual swaps as a crypto hedging strategy, it’s essential to understand the funding rate mechanism and the potential returns of your collateral. Additionally, be mindful of the leverage the chosen exchange offers, as some cryptocurrency exchanges provide up to 100x leverage on derivatives.
Also Read, 10 Best FREE Trading Indicators for Traders
Crypto Hedging pros and cons
| Pros | Cons |
| Hedging tools can also be used for locking the profit. | Hedging involves costs that can eat up the profit. |
| Hedging enables traders to pull through hard market periods | It requires experience and a good trading strategy . |
| Hedging can save time as a long time trader. | Reducing risk leads to reduction in profits. |
| It is a short term risk-managing strategy | Difficult and hard to follow . |
Conclusion
In conclusion, crypto hedging is a vital risk management tool for traders in the cryptocurrency market, especially due to its high volatility. Diversifying portfolios, using options, futures, and perpetual swaps are all viable ways to protect investments and increase profits.
However, traders must exercise caution when using leverage and thoroughly understand the mechanics of each hedging method to make informed decisions.
Frequently asked questions
What are the three common hedging strategies?
The three common hedging strategies include :
Portfolio diversification
Hedging with options
Hedging with futures
Why to diversify hedging strategies?
To maximize your revenue, diversify your investments to lower the risk you are exposed to. Although some risks, such as systematic hazards, are unavoidable, you may protect yourself against unsystematic risks like commercial or financial risks.
Why is hedging important in crypto?
Hedging is important in crypto because the market is very volatile and unpredictable, and there are many risks such as hacking, regulation, and fraud.
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