Hedging is a trade initiated to reduce the risks of conflicting price trends seen in a particular asset. In addition, crypto hedging enables a trader to open more than one concurrent bet, minimizing the risks of drastic losses.
The concept of hedging has been around for decades. It is being used not just in cryptocurrencies but in every major segment of finance. Hedging allows an investor to secure a stable revenue out of their investments even during undesirable market conditions.
Hedging can protect an investor's asset from adverse market
fluctuations, but it will also limit the potential profits that the investor
could have gotten. But many swing traders and investors with substantial
capital invested might agree to this risk-averse strategy rather than lose
money in wrong trades. Hedging thus acts as insurance of a trade, which will be
invoked if gone wrong.
Why Is Hedging Important?
A company looking to hedge its investment can use options,
forwards, futures, and swaps. Options are contracts that give buyers the right
but not the obligation to buy or sell an asset at a predetermined price on or
before a specific date. Forwards are similar to options, but they must be
settled on the same day their buyers bought them. Futures are financial instruments
similar to options, but they occur through exchanges and settlements on
specific dates in future months.
A) Volatility
For the most part, cryptocurrencies are volatile assets;
they are unregulated and, at times, unstable. Therefore, even after charting an
asset perfectly and opening a trade accordingly, you might have to experience
trend reversal in the opposite (than expected) direction.
B) Bitcoin Dominance
Altcoins follow Bitcoin’s price actions, i.e., if Bitcoin dumps, altcoins generally will, too, and if Bitcoin pumps, the altcoin will too. This is because Bitcoin constitutes more than 40% of the crypto space and hence the most dominating cryptocurrency. But if a coin is nearing a breakout or has broken out due to some recent developments and Bitcoin dumps, that breakout would abruptly turn into a fakeout.
Types of hedging
1. Future hedging
Futures contracts—also just called futures—are sometimes
used by corporations and investors as a hedging strategy. Hedging refers to a
range of investment strategies that are meant to decrease the risk experienced
by investors and corporations. A future is a contract in which two parties
exchange cash flows at a specified price on a specified date. This is called a
forward contract. It’s also possible to buy or sell an option attached to a
forward contract – a futures option.
2. Forwards hedging
A forward contract is an agreement between two parties to exchange a specific amount of cash for a given asset at a specified price in the future. The seller agrees to buy the asset at that price, and the buyer agrees to sell it. This is often used for oil or currency transactions.
To
calculate the forward rate, multiply the spot rate by the ratio of interest
rates and adjust for the time until expiration. So, the forward rate is equal
to the spot rate x (1 + domestic interest rate) / (1 + foreign interest rate).
3. Option hedging
A hedge is an investment that protects your portfolio from adverse price movements. Put options give investors the right to sell an asset at a specified price within a predetermined time frame. Investors can buy put options as a form of downside protection for their long positions.
This means
if you think that the bitcoin price will increase, you can buy the call option
to benefit from this situation. The downside is that if the buyer doesn’t
exercise the call option will be limited to the cost of buying at that time.
4. Swap hedging
Swap contracts, or swaps, are a hedging tool that involves
two parties exchanging an initial amount of currency, then sending back small
amounts as interest and, finally, swapping back the initial amount. These are tailored
contracts and the exchange rate of the initial exchange remains for the
duration of the deal.
5. Foreign Exchange hedging
A forex hedge is a transaction implemented to protect an existing or anticipated position from an unwanted move in exchange rates. Forex hedges are used by a broad range of market participants, including investors, traders and businesses. By using a forex hedge properly, an individual who is long a foreign currency pair or expecting to be in the future via a transaction can be protected from downside risk.
Alternatively, a trader or investor who is
short a foreign currency pair can protect against upside risk using a forex
hedge.
4 Best hedging strategies
1. Short Selling
In short selling, traders take a position to short an asset when they believe that their spot holding will temporarily(or for an indefinite amount of time) fall in value. With short selling, traders can also sell their spot holdings and buy back when the price is lower, securing the gains and thus securing more buying power.
In other words, short selling allows investors to hedge against the downside risk of a long position in the same cryptocurrency or a related one. Short selling in cryptocurrencies protects against long exposure. However, shorting might bring complexity to margin trading since increased borrowing power could raise your liquidation price.
2. Futures
Future is essentially a contract between two or more parties that agrees to buy or sell an asset in the future at a pre-determined and agreed-upon time. In secondary markets, the futures contract can be sold before the agreed-upon date. Futures contracts are part of many trading instruments known as derivatives, including Contracts for Difference (CFDs), Options, and Swaps. Investors can open a short position when they think a pullback is due; in secondary markets, they can open a short position, earn some capital and invest when the price is lower.
Cryptocurrency futures allow users to leave their position open, maximizing their profits from your crypto investments. Futures contracts can be a good hedge for investments or lock your profits in a volatile market such as cryptocurrency. These are ideal for investors who want to hedge their exposure in the crypto market for a reasonable period.
3. Perpetual Swaps
Perpetual swap also falls into the category of derivatives that allows an investor to buy or sell(long or short) the value of an underlying asset without the need for an expiration period for the position (long/short). In perpetual swaps, investors can exit at any time they want.
With perpetual swaps, investors can get more buying power than they have; hence it is easier to take advantage of price fluctuations while holding your position on the spot. Additionally, perpetual swaps operate on a funding rate mechanism that rebates to continue holding the position. The fee is deducted from the margin provided by the investor.
This strategy has gained traction in the crypto market since it enables traders to leverage positions without an expiration date. Perpetual swaps have proven to be a great aid to retailers who want to increase their buying power. The perpetual swap also incentivizes traders to long the asset when the index price is bearish. The funding rates are usually designed to ensure price stability.
4. Options
Options also fall into the category of derivatives in crypto. They allow investors to bet on the underlying asset's increase, decrease, or volatility without actually buying or selling it. With options, investors can hedge in cryptocurrencies by limiting downward losses in a declining market. The 'put' option means that an investor is betting on a price drop, and it will increase in value when the underlying asset declines below the option's exercise price.
Thus, the put option results in a significant level of leveraged hedge protection at a relatively lower cost. Hedging is not 100% risk-free, like any other strategy in the finance sector, and it does not guarantee the success of your investment. It can turn in a profit and allow a lower buying price, but it can also lead to significant losses if not applied properly at the right time.
But for a large portfolio, the benefits of hedging outweigh the benefit of not hedging, and therefore exercising crypto hedging, especially for swing traders, is advisable. It’s also important to know that, as investors get older, they start trying harder to control their investments by pushing them into different asset classes, which skew the ratios.
This means a valuable portfolio for younger investors might not be helpful for older ones. In other words, non-disabled investors need to consider how long-term gains will counterbalance longer-term losses.
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