Risks are inevitable in investments. No matter what you’re investing in, there are always risks involved. To curb losses or prevent the losses from being huge, people “hedge” their investments. A hedge is simply placing barriers to prevent or reduce the effects of risks in your investments.
Think of hedging as wanting to jump from a 10-story building but setting plush cushions on the ground. While you crash to the ground, the hedge you’ve formed (the cushions) will prevent you from taking a harder fall than you’re supposed to. Many financial investors hedge their funds against losses. In cryptocurrency trading, traders deploy many strategies to hedge their funds against market swings.
If you’ve wanted to learn about hedging cryptocurrency or wonder what it is, we have carefully explained the fundamental aspects of hedging that you need to know.
What is Hedging?
As explained earlier, hedging means putting barriers that reduce the effects of risk in your investment. It gives your investment portfolio a soft landing when risks hit. The concept of hedging has been around since as far back as the late 1800s and was used by French financial traders. They did this by creating specific positions to protect their portfolio, regardless of the market’s speed or direction.
In 1900, Louis Bachelier— a “financial analyst” in the Paris Bourse— wrote a dissertation titled “The Theory of Speculation.” This dissertation was the first to analyze this financial trading model using mathematical formulas. Later in the 1970s, Paul Samuelson— a Nobel prize winner and widely known economist— pushed for the dissertation to be translated into English. Then, two economists— Fischer Black and Myron Scholes— read the work and co-published an article titled “Journal of the Political Economy” in 1973, which became one of the most famous articles in the world of financial exchange.
In the modern-day, hedging has also been adopted in the cryptocurrency world. It is used in setting and insuring crypto trades by holding two or more trades in different assets or positions. For example, they might hold a long position in ADA and a short position on ETH or a long and short position in ADA.
One important thing to note is that hedging reduces the profit percentage. One rule of investing is “higher risks, higher rewards.” Hedging makes that impossible because it reduces the risks, thus reducing the rewards. Hedging has many benefits, but it also has its limitations. It is important to study different hedging strategies to adopt the one best suited for you.
Why Hedge Cryptocurrency?
Hedging cryptocurrency is done for a couple of reasons, which we’ll discuss in the following paragraphs.
Crypto price swings are unpredictable and are part of the reasons why crypto trading is very high-risk. For example, Bitcoin rose to $62,000 in October, reached an all-time high of $69,000 in November, and finally crashed to below $35,000 by January 2022. Asides from complicating the price predictions, the market instability makes long positions more difficult and could negatively impact them.
Crypto scams are pretty common, and it is reported that about $10B have been stolen through crypto scams. The most common ways scams are carried out are phishing, rug-pulling, and crazy investment schemes. Things like this make investors wary about investing in crypto and also increase the risks involved, as there’s always a risk of a project being a scam, your wallet getting hacked, and so on.
Cryptocurrency is generally not classified as legal assets or financial instruments, especially in the US. Since the government does not regulate it, there can be some sort of “manipulation” where some key players get to decide the fate of a coin and benefit from that decision. One example is the LUNA crypto network that crashed unexpectedly and wiped over $60 billion from the crypto market. Occurrences like this increase the risk of crypto trading, as you never know which project is being manipulated or might be rug-pulled.
Crypto transactions are irreversible, which means that whatever you put in cannot be changed. This means you must analyze carefully before making a trade, as there is no room for mistakes. The fact that crypto transactions are irreversible adds to the overall risk quotient of cryptocurrency, making it a high-risk venture.
How To Hedge Cryptocurrency?
There are different ways of hedging crypto to mitigate the risks and earn profits.
Short selling is simply taking a position to sell a cryptocurrency when the trader believes that it’ll be at a reduced price and hope to profit from it by repurchasing the asset at that price or profiting from the difference. This trade is usually completed within days. Short selling helps investors hedge the downside risk of holding a long position for the same cryptocurrency or a related cryptocurrency asset class.
It can be done by:
- Traditional short-selling— borrowing from an exchange or third party, selling it, and rebuying it at a lower price.
- Margin trading— borrowing from exchange to make a trade and using leverages to maximize the chances of potential profits or losses.
Regardless of if you’re shorting for hedging or speculation purposes, shorting is a complex process, which should be done calculatively, and with a good knowledge of market analysis.
Options are part of a large class of trading instruments known as derivatives, which also have others like contracts for differences (CFDs), futures, and swaps. They are used to set a position that allows the trader to buy/sell an asset at a specific price or around a particular date. Options help hedge cryptocurrency by blocking downward losses when the market declines.
Options come in two forms:
- Call options— you buy a stock that decreases in value when the asset goes lower than the option’s exercise price.
- Put options— you sell a stock that increases in value when the asset declines below the option’s exercise price.
These result in a level of leveraged hedge protection at a lower cost. Options can also be used for speculations to determine the direction in which a cryptocurrency moves.
Futures are agreements to buy/sell an asset on a particular day at a specific price. As a secondary market, futures can also be sold before the date. Doing this helps to increase investors’ liquidity. In cryptocurrency trading, futures let you leave an open position, which helps to maximize profits. They help hedge funds by locking profits at different positions in the volatile crypto market for a particular time.
By doing so, they reduce the risk of crashing prices by taking a short future position and benefit from the increasing prices by taking a long future position. Futures help speculate market directions and curb the risks of unfavorable price fluctuations, however, you must have an outstanding knowledge of market analysis before attempting to hedge using futures.
How To Hedge Spot Positions?
When spot trading, it is advised to use perpetual swaps derivatives as a form of hedging. Perpetual swaps let you buy and sell the value of an asset, even without setting an expiry date for the position. This means that you have the choice of taking or exiting a position at any time. Since you have more buying power when using perpetual swaps, you can easily position yourself better to benefit from price fluctuations. They also have a funding rate mechanism where you pay a fee to retain your position.
To use perpetual swaps for hedging, you need to ascertain your collateral’s funding rate mechanism and potential profits. You also need to know the leverage that your preferred exchange permits. The perpetual swaps strategy is popular amongst traders as it offers leverage on positions without a deadline. It is worth noting that a perpetual swap is traded alongside the index price of the asset.
What Are The Best Hedging Strategies?
Options have typically been regarded as the best hedging strategy. You can use the “put option” with an extended expiry period, as a low strike price offers good protection against adverse price fluctuations. Note that there is no “perfect” hedging strategy. Still, the best you can do is look at different hedging strategies and determine the best one for you, depending on your trading needs, capital, and other vital factors.
By using hedging strategies, many traders feel more convinced that their assets are secure. After a while, when you are convinced that you know the directions in which your trades are headed, you can take off the hedges. You should also know that the market is unpredictable, and things could take a different turn, which is why it is advised for you to be sure and not make careless, uncalculated decisions while setting trades.
Hedging is like insurance against losses; it doesn’t mean that your assets are 100% safe. If they were, there would be no profits, and the essence of trading is to take risks involved to make profits. However, the goal is to be able to minimize risks. Once you can minimize your risks and you’re able to discipline yourself to stay within your risk limits, you can make safe profits with minimal losses.
Diana is the CTO of Vestinda.
She’s an engineer with extensive experience in the payments space, passionate about mathematics and artificial intelligence.