Hedging is fundamentally a risk management strategy that traders use to even out investment losses. Thus, it refers to taking an opposite stance of the current open stance in a particular asset. In simple words, ‘swimming against the currents’, but to counterbalance the possibilities of ‘investment losses’. Hedge against crypto helps one to minimize risks in their portfolio.
That being the case, Hedging represents a form of insurance that secures traders against a negative event’s impact on their investments.
While we are at it, we might as well understand the ways we can gamble the predictions of the market and prepare for what might not turn into our favour as a trader.
There are multiple ways to hedge against crypto assets in order to minimize any kind of loss that one may incur while trading them. Here are three common hedging strategies against crypto.
- Portfolio Diversification,
- Short Selling and
- Trading Derivatives
1. Portfolio Diversification
Portfolio diversification is the simplest way to secure your investment. It enables traders to play safe and minimize their chances of loss very easily. Diversification means that you should buy multiple crypto assets instead of investing all your funds into one cryptocurrency. Thus, resounding the age-old proverb: “ You should not put all the eggs in one basket ”.
A diverse portfolio strategy works on assets that do not flow in the same current. Hence, it is preferable to invest in non-correlated assets. However, it is also worth mentioning that all the cryptocurrencies tend to move in the same direction, following the waves of Bitcoin and Ethereum. Therefore, it may be difficult to maintain a fully diversified “crypto-only” portfolio.
Consequently, traders can also look beyond and outside of the crypto market, as correlation between Bitcoin and traditional stock markets is very weak.
2. Short Selling
Short selling is an advanced technique, used by traders to hedge in the market. Short- selling refers to the trading practice of selling an asset when it is predicted that it will soon drop in price, and then at a later point, repurchasing it at a lower price.
By doing this, traders make profit from the price difference. Although it sounds like ‘a psychic skill’, short selling in cryptocurrencies will protect you against long exposure.
But, the catch in the situation is that shorting typically adds ‘complexity’ to the crypto market. Therefore, be careful with this double-edged tactic, in case you intend to short crypto for hedging or use it for speculations.
So, you can short cryptocurrencies in different ways, including:
- Margin trading, here you can borrow from a broker to make a trade. Exchanges that allow margin trading also offer leverage. However, they can increase the likelihood of both profits or losses.
- Traditional short selling is when you borrow from a broker, credit platform or any third party, and then sell the crypto assets at the market price. Later on, you can wait for a lower price and then repurchase the asset to pay back your debt.
3. Trading Derivatives
Using derivatives is also one way to hedge against crypto. Derivatives refer to those contracts that derive their value from a primary underlying asset. T
Here are multiple strategies that you can implement for derivative contracts.
i ) Futures Contract
As the name suggests, a futures contract refers to ‘a financial contract between two or more parties that have agreed to trade a particular crypto asset at a predetermined price, on a specific date in the future’. Because it has a secondary market of its own, you can always sell the futures contract before the agreed-upon date.
Thus, a cryptocurrency futures contract helps traders mitigate the risk of falling prices by taking a ‘short future position’, and also benefits the traders when the price increases by taking a ‘long position’ with a futures contract. Cryptocurrency futures allow you to leave your positions open, thus giving more space so that you can maximize your profits.
ii ) Perpetual Swaps
Perpetual swaps refer to derivative contracts that enable you to buy or sell the value of an underlying asset without determining an expiration date for the position you take. In this, you can choose when to take or exit a position at any time. Perpetual swaps provide you with “more buying power” than you would have, when spot trading. Thus, they certainly place you in a better position to take advantage, in case price swings in your favour.
Perpetual swaps function under a funding rate mechanism in which you have to pay a fee or else you get a rebate when you keep on holding your position. Before you use 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 provided by the exchange you choose. This is so, as some crypto-exchanges allow up to 100x leverage on derivatives.
This strategy has quickly become popular in the crypto market. Using this strategy, traders can take leverage positions without an expiration date. The key difference is that these swaps are traded very close to the index price of the underlying asset.
Perpetual swap also charges funding rates. Traders are incentivized to buy perpetual swaps when the index price is bullish. The funding rates are thus designed to ensure price stability in the market.
Options trading are derivative contracts that provide investors the right but not the obligation to buy or sell a specific asset at a defined price and date. Option contracts come with “call options” or “put options”. A call option gives you the right to buy a cryptocurrency, while a put option empowers you with the right to sell a cryptocurrency.
Options contracts help traders to hedge crypto by limiting losses in a declining market. When the underlying asset declines below the exercise price of the option, the “put options” increases in value and the “call options” decreases. With the options, trading can gain a significant level of leveraged hedge protection at a relatively lower cost.
Some traders also use option contracts to speculate the market directions.
With almost every other person catching the wind of crypto investments; one might get trapped into believing that they need to catch up on the trend. This is certainly not how one should go about cryptos.
While the anonymity of crypto transactions are the crux of these modern markets, they are the subject of apprehension too. Because there are no clear regulations here, one must keep an eye out for ‘secure cryptos’ while also evaluating the market before investing in it.
Before you invest your hard-earned money into any market, it is always advised that you must do your own research.