Hedging Bitcoin: A Crypto Risk Management Strategy

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  • What is hedging in trading: Hedging is a risk management strategy that traders use to offset investment losses.
  • The three most common methods are portfolio diversification, short-selling assets, and the usage of derivatives like futures.
  • Hedging cryptocurrency is not entirely risk-free. There is no guarantee that the price of a particular asset will fall or rise, even if the price chart shows relevant signals.


What is Hedging?

Hedging is a risk management strategy that traders use to offset investment losses. The act of hedging refers to taking a position opposite the current open position in a particular asset. Traders treat it as a form of insurance that protects them against a negative event’s impact on their investments. Keep in mind that hedging does not prevent adverse events from happening. Instead, it is a strategy that reduces the financial impact.

Why Hedge Cryptocurrency?

The cryptocurrency market is highly volatile. Sharp and sudden price swings are prevalent where prices rise as quickly as they fall. For example, in January 2021, Dogecoin’s (DOGE) price received a generous boost within 24 hours from around $0.008 to about $0.08. However, the price plummeted by approximately 72% the next day to $0.022. Even though DOGE’s price climbed higher and higher in the following months, not all cryptocurrencies made the same recovery.

Interestingly, many crypto traders view market volatility as a chance to make money, but at the same time, they expose themselves to an increased risk of encountering huge losses.

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Separately, cryptocurrencies were created with decentralization in mind. By their nature, cryptocurrencies lack the regulation that most financial institutions have. Therefore, the cryptocurrency market is not subject to the requirements, restrictions, and guidelines that traditional financial institutions follow. Unfortunately, this lack of regulation also limits the amount of protection crypto traders enjoy, thus increasing the possibility of suffering huge losses. As a result, crypto traders must rely on experience, individual judgement, and the market when trading cryptocurrency.

How to use Hedging to minimize trading risks?

In particular, traders can employ risk management strategies like hedging to minimize cryptocurrency trading risks, such as those above. For example, suppose a trader currently holds a profitable position in Bitcoin (BTC), but the trader predicts and believes that Bitcoin’s price will drop, either due to his own intuition or from information he is getting from the market. Hence, he or she plans to hedge the asset. To hedge, the trader adds a second position opposite the current profitable one to protect their positive unrealized profits. As the market direction changes, the initial profitable position may turn negative. On the other hand, the secondary position taken during hedging will produce a profit, covering part of the losses from the initial position. This is commonly done by short-selling or by trading futures.

How To Hedge Cryptocurrency?

There are various cryptocurrency hedging strategies that traders can use to mitigate risk. The three most common methods are portfolio diversification, short-selling, and the usage of derivatives like futures.

Therefore, hedging is not an isolated investment strategy in itself, but rather the utilization of various other risk management strategies in the context of a particular market downturn.

Portfolio Diversification

Having a diversified portfolio can be the simplest way for traders to minimize losses in the cryptocurrency market. Diversification refers to purchasing various crypto assets instead of investing all funds into one cryptocurrency. In other words, “not putting all your eggs into one basket.”

In a diverse portfolio, each cryptocurrency acts as a hedge to another. As a result, when the price of one token falls, the overall loss is lower than if a trader were to invest the entirety of their funds into one cryptocurrency.

A diversified strategy generally and preferably involves putting funds into investments that do not move in a uniform direction. The most optimal scenario is that a trader invests in various unrelated or non-correlated assets. However, the cryptocurrency market is different from the traditional stock market, which hosts multiple asset classes and contains a diverse set of industries. Cryptocurrency assets are pretty similar and tend to move in the same market direction. Therefore, it may be difficult to achieve a fully diversified crypto-only portfolio.

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Nevertheless, crypto traders should still formulate a suitable portfolio diversification strategy. Traders should do their own research on which cryptocurrencies to include in their portfolios. Generally, a portfolio should have a good mix of different coins and include reputable coins, such as Bitcoin (BTC) and Ethereum (ETH), to offset the higher risks associated with altcoins.

If investors want to look outside of crypto to diversify, that is also okay. Bitcoin has been viewed as an asset that isn’t correlated with many others, and has a low correlation with stocks (the S&P 500 index), and a pretty low correlation with technology stocks, as represented by the large-capitalization oriented Nasdaq-100 index. Therefore, if one wants to diversify away from Bitcoin, these would be viable options.

According to Dow Jones MarketWatch data, Bitcoin’s correlation with the Nasdaq-100, as measured in late May, was around 0.20 on a rolling 20-day average, and its correlation with the S&P 500 is 0.29, as of June 2. On the other hand, Michael Saylor’s MicroStrategy has a much higher correlation of 0.73. This means that if one wants to pursue a diversified hedging strategy against falling crypto prices, it’s safer to invest in less correlated assets, such as Nasdaq or S&P 500 stocks, but paying particular attention to avoiding those that move with the cryptocurrency industry.

Short-selling Assets to Hedge Crypto

Short-selling assets is a more advanced way for traders to hedge cryptocurrency. Short-selling refers to the trading practice of selling a particular asset when it is believed that the asset will soon drop in price, and then repurchasing it at a lower price. By doing so, traders profit from the difference.

Short-selling starts with traders analyzing the price chart of a specific cryptocurrency. For example, using divergence analysis to determine the signs of a potential trend reversal. Once traders see signs of a trend reversing downwards, they can borrow a sum of a specified crypto from an exchange or a broker and sell the borrowed tokens on the market. Once the crypto’s price falls, they can repurchase the same amount of tokens at a lower price and return them to the exchange or broker. However, if the price increases, traders would have to buy back the same amount of tokens at a higher price and lose money.

Example of a Short Selling

For example, suppose a trader wishes to short BTC and borrows $1,000 of BTC at $60,000. If BTC’s price drops to $50,000, the trader would only need to spend $833 to buy back the same amount of BTC, thereby pocketing a $167 profit. However, if BTC’s price rises to $70,000, the trader would need to pay $1,167 to buy back the same amount of BTC, thereby taking a $167 loss. Traders may opt to set a stop-loss limit near the initial price of $60,000 to avoid massive losses.

It is important to note that hedging via short-selling comes with transaction costs and margin interests, which can eat into profits. Thus, traders should make proper calculations before borrowing and selling a particular cryptocurrency.

Making Use of Futures to Hedge Crypto

Traders can also use derivatives to hedge cryptocurrency. Derivatives refer to contracts that derive their value from a primary underlying asset. The most common derivatives that traders use for hedging cryptocurrency are futures. A future is a type of 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. A cryptocurrency future helps traders mitigate the risk of falling prices by taking a short future position, and profiting when the price increases by taking a long future position.

Example of using derivatives to hedge crypto

As an example, suppose a trader holds 1 BTC, worth $60,000, and wishes to lock in at this price. Each futures contract is worth $1 of BTC at this price, so when the trader opens a position, he would need 60,000 contracts. The trader is preparing to short the contracts in anticipation of a price and sells them. If the price does fall at the predetermined date, the trader buys back the futures at a lower price, pocketing the difference. However, if the price increases, the trader would incur a loss by buying back the futures at a higher price. On the other hand, if the trader takes a long position and holds the contracts, they would profit when the price rises and incur losses when the price falls.

If traders make use of the high degree of leverage in futures trading, their profits may receive a boost. However, during unfavorable conditions, the losses incurred will be higher as well. Therefore, traders should be cautious of the risks using leverage poses when trading futures.

What is a Short Hedge?

More often, the use of derivatives and shorting in the context of hedging is called a short hedge. A short hedge involves shorting an asset or using a derivative contract that hedges against potential losses in an owned investment by selling at a specified price.

How To Hedge Cryptocurrency Correctly?

For novice traders worried about the risks to trading and don’t have the time to study the charts, they should pick the safer option and close their position or reduce its size. For others, hedging can be a useful strategy to maintain their holdings and mitigate losses during a market downturn.

Four Steps to hedge Crypto

To ensure that hedging is done correctly, traders may follow the steps below:

  1. Traders should conduct research prior to applying hedging strategies and learn how to use, read, and analyze price charts.
  2. Traders should learn how to trade on a cryptocurrency exchange.
  3. Once traders understand how to trade cryptocurrency, they can start to practice their hedging strategy by utilizing a simulated trading
  4. After traders get the hang of it, they can start hedging real cryptocurrency in small amounts and slowly move on to bigger positions later.

When traders are hedging cryptocurrency, the golden rule is to take a position opposite the current position, which means traders should take a short position if they think the price of a particular asset will fall and take a long position if they anticipate the price will rise. However, hedging cryptocurrency is not entirely risk-free. There is no guarantee that the price of a particular asset will fall or rise, even if the price chart shows relevant signals. As a result, traders should weigh the pros and cons when deciding which cryptocurrency to hedge and what hedging strategy to use.

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Hedging is a popular strategy that traders use to mitigate risks in the traditional stock market and the cryptocurrency market. It is a useful tool to maintain crypto holdings and protect profits in the highly volatile investing environment. The three most common cryptocurrency hedging strategies are portfolio diversification, short-selling, and trading derivatives. When applying hedging strategies, traders should take note of the transaction fees and the risks to using leverage that may cut into their earnings.

Traders should keep in mind that hedging is a risk management strategy. There is no guarantee that hedging will mitigate risks, as it can sometimes be counterproductive and limit the amount of profit that would have been realized. Therefore, traders are advised to understand the available hedging tools and practice with such tools before utilizing them in trading.

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