As we all know, cryptocurrency trading can be a risky investment. The market downturn is inevitable. As a trader, you need to find a way to protect your investment from risks. This is where crypto hedging strategies come in. Hedging involves opening positions in the opposite market direction to reduce the risk and impact of market fluctuations.
But what is a hedging strategy? What is the risk of cryptocurrency? How to apply risk hedging strategies to cryptocurrencies? Is hedging 100% risk-free? If these questions confuse you, then you have come to the right place. This article will explore everything you need to know about hedging. In addition, we will show you four crypto hedging strategies that can be easily applied.
In fact, the introduction of crypto hedging has melted the crypto bubble of 2018.
Let’s learn more.
What is a hedging strategy?
According to Investopedia, hedging is an investment designed to reduce the risk of adverse changes in asset prices. Hedging strategies enable traders to simultaneously place multiple bets in opposite directions to minimize the risk of huge losses.
For a long time, as a risk management technology for crypto traders, hedging has always been a financial market strategy. It allows you to maintain a stable value for your investment under unfavorable market conditions (without generating substantial returns).
Although cryptocurrency hedging can protect your assets from adverse market changes, it also limits the potential gains you can get from cryptocurrency investments. However, for risk-averse cryptocurrency traders, this is a better option than losing all of their assets due to unfavorable price fluctuations in the cryptocurrency market.
Types of risks in cryptocurrencies
Very similar to the foreign exchange market, the cryptocurrency market has similar risk forms: volatility risk , regulatory risk , transaction risk, and leverage risk .
Cryptocurrency risk (like most financial instruments) usually stems from the volatility of these currencies. Cryptocurrency trading is mainly speculative. Therefore, before you start trading, you must understand these risks.
Cryptocurrency is unstable
Due to the high volatility of cryptocurrencies, as market sentiment changes, prices tend to fluctuate sharply and suddenly. The value of cryptocurrency often fluctuates rapidly, with fluctuations of hundreds or even thousands of dollars each time.
In January 2021, Dogecoin rose by more than 800% in 24 hours, and the price fell by more than 500% the next day.
Cryptocurrency is not regulated
Neither the government nor the central bank regulates cryptocurrencies. Although governments and financial institutions are beginning to take notice of this, there is still uncertainty as to whether it is classified as a commodity or a virtual currency.
Due to the lack of supervision, the protection of buyers and sellers is limited, so that investors can only rely on development projects, personal and personal experience when making investment decisions.
Communication errors and delays in trader order transactions may cause huge losses to cryptocurrency traders. Therefore, it is important to choose an exchange that can handle a large number of transactions per second (TPS). For example, Bybit leads the crypto industry by processing up to 100,000 TPS/data, and it also provides traceability methods for crypto traders.
With the lower profit margins on margin deposits and collateral, traders can enjoy high leverage. Traders need to be cautious in using aggressive leverage that may increase losses under adverse conditions.
Now that we have covered the downside risks of cryptocurrencies, let us delve into the hedging risks of cryptocurrencies.
The golden rule of hedging
If you are overly worried about the risk of your position, then it is safer to close your position completely or reduce the size of your position. However, if you want to maintain your cryptocurrency holdings and create neutral risk exposure, hedging may be a useful strategy. Before applying a hedging strategy, you should keep in mind the following principles:
1. Opposite positions: The rules are simple. Traders should hold positions that are opposite to their current positions. For example, if you predict that the price of cryptocurrencies will rise, you should establish a long position.
2. Liquidity assessment: Traders and investors pay close attention to the liquidity of new assets to determine market integrity, transaction speed and market liquidity, so that traders can quickly convert assets into cash without too much Price slippage.
3. Decentralized investment: For traders and investors, diversified investment is one of the best fund management techniques, which is an open secret. You can establish multiple positions in Bitcoin (BTC), Ethereum (ETH), Chainlink (LINK) and many other tokens to create a diversified portfolio of derivatives.
Types of hedging strategies
You can deploy cryptocurrency hedging strategies in a variety of ways. Here are the four most popular methods.
Short selling refers to holding a position to sell assets when a trader believes that an investment will depreciate. As a trader, you can expect to profit by buying back at a lower price-or profit from the difference. Shorting cryptocurrencies can prevent long-term risk exposure.
According to Investopedia, shorting allows investors to hedge the downside risks of long positions in the same security or related securities.
Shorting usually increases the complexity of cryptocurrencies. Therefore, whether you are shorting cryptocurrencies for hedging or speculation, beware of this strategy. You can short cryptocurrencies in different ways, including:
- For margin trading, you can borrow money from a broker to trade. Exchanges that allow margin trading also provide leverage, which can increase potential profits or losses.
- In traditional short selling, you borrow from a broker, lending platform or a third party, and then sell cryptocurrency and repurchase it at a better price.
Disadvantages of shorting
The potential loss of shorting may be unlimited. You can yearn for a cryptocurrency that may fluctuate to a price of $0, resulting in a complete loss. Therefore, in order to avoid catastrophic losses, traders will set a stop loss limit in the initial investment.
In the financial field, futures refers to an agreement to sell or buy assets at a specific price on a specific future date. Since it has its own secondary market, futures can be sold before the agreed date. This increases the liquidity of investors and business owners. Futures contracts are part of a large trading instrument called derivatives, including contracts for difference (CFD), options and contracts.
The operation of cryptocurrency futures also follows a similar philosophy. Due to the volatility of cryptocurrencies, most traders buy when the price is low and sell when the price is high. However, such buying and selling may cause investors to miss potential profits.
Cryptocurrency futures allow you to keep open positions, thereby maximizing your profit from crypto investments. Currently, CME Group offers several Bitcoin futures with different expiration dates, for example in its Bitcoin futures calendar. All contracts are settled in U.S. dollars on the expiry date.
Futures contracts hedge your investment or lock your profits in volatile markets such as cryptocurrencies. They are ideal for investors who want to hedge their exposure to the crypto market within a reasonable period of time.
Benefits of futures:
- Reduce the risk of falling prices by holding short futures positions, and benefit from rising prices by holding long futures positions
- Futures allow you to speculate on the market direction
- Futures help smooth your risk exposure and stabilize price fluctuations
As mentioned above, the risk of hedging through futures includes leverage risk. However, leverage risk is still one of the popular options for cryptocurrency hedging.
3. Perpetual Contract
A perpetual contract is a derivative that allows you to trade the value of the underlying asset without having to set an expiration date for the position you hold (you can choose when to open or exit the position at any time).
Compared with spot transactions, perpetual contracts provide you with more purchasing power. Therefore, you can make better use of price fluctuations. Perpetual contracts operate under the funding rate mechanism, and you pay fees or rebates to continue holding your position.
Before using perpetual contracts as a hedging strategy, you need to determine the financing interest rate mechanism and potential returns of your collateral. You also need to understand the leverage allowed by your chosen exchange (derivatives can allow up to 100 times leverage).
This strategy quickly became notorious in the crypto market. It enables traders to take advantage of positions without expiry date. The main difference is that the transaction price of the perpetual contract is close to the index price of the underlying asset.
Perpetual contracts also charge funding rates. This will incentivize traders to buy perpetual contracts when the index price is bullish. The financing rate is usually designed to ensure price stability.
Because it does not depend on the expiry date, perpetual contracts have quickly become popular on BitMEX. They will soon be adopted by mainstream cryptocurrency exchanges, including Bybit and Binance.
The advantages of perpetual contracts as a hedging strategy:
- They provide greater liquidity, making it easier for more traders to participate
- The higher leverage provided means you can earn more with less money
- They are ideal for short-term hedging
However, due to fluctuations in funding rates, perpetual contracts may make hedging costs unpredictable. The loss of high leverage may also be greater.
Option is another derivative of cryptocurrency. They allow investors the right (but no obligation) to trade the underlying asset at a specific price or before a specific date. You can use options as a way of hedging cryptocurrencies by limiting downside losses in falling markets.
When the underlying asset falls below the option strike price, the value of the put option increases, while the call option decreases. This leads to a high level of leveraged hedging protection at a relatively low cost.
You can also use options to speculate on the direction of the cryptocurrency. Options are call options or put options. Call options give you the right to buy cryptocurrencies, and put options give you the right to sell cryptocurrencies.
Advantages of using options to hedge cryptocurrency risks:
- Limited down space, unlimited up space
- More predictable
Disadvantages of options
The main disadvantage of using options is the expiry date. Long-term options can be expensive, while short-term options can cause options to expire before they provide you with the hedging protection you need.
Is hedging 100% risk-free?
Hedging is not 100% risk-free. Although investors use hedging to protect themselves from market fluctuations, hedging comes with risks. It does not guarantee the success of your investment. It also cannot ensure that your investment reduces risk.
When choosing a crypto hedging strategy, the best way 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 are greater than the costs of hedging.
In some cases, hedging can be counterproductive, especially when the market remains neutral (you still have to pay the cost of hedging).
to sum up
Cryptocurrency is indeed a volatile financial instrument, which carries certain risks for investors. Regardless of market conditions, cryptocurrency traders should understand financial strategies such as hedging to minimize potential losses and protect their positions.
Hedging protects you from the huge losses you may suffer in the highly volatile cryptocurrency market. Another reason why hedging cryptocurrencies is crucial is that it can protect your profits in the event of a crash or price adjustment.