Hedging Bitcoin: 5 Risk Management Strategies in Crypto Trading
- Hedging is not an isolated investment strategy in itself, but rather the utilization of various other risk management strategies to manage market volatility.
- The 5 common risk management strategies in crypto trading are portfolio diversification, hedge mode trading, hedging with options and futures, and dollar-cost averaging.
- Hedge mode trading involves taking both long and short positions on a contract, significantly lowering the risk of liquidation.
What is Hedging?
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 the impact of a negative event.
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.
Naturally, this same volatility that enables crypto traders to make money also creates risk. Hedging enables traders to manage this risk.
For example, suppose a trader currently holds a profitable position in Bitcoin (BTC). The trader predicts that Bitcoin will drop in price soon and plans to hedge the asset. By hedging, 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.
How To Hedge Bitcoin In Cryptocurrency Trading
There are five key cryptocurrency hedging strategies that traders can use to mitigate risks:
1) Portfolio Diversification
Having a diversified portfolio can be the simplest, fool-proof 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 a diverse portfolio, each asset acts as a hedge to another. As a result, when the price of one falls, the overall loss is lower than if a trader were to invest the entirety of their funds into one asset.
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.
Generally, in a crypto-only portfolio, diversification can be something as simple as having a mix of large-cap coins such as Bitcoin (BTC) and Ethereum (ETH), as well as altcoins; the large caps offsets the higher risks associated with altcoins, while the altcoins have the potential for much higher gains.
However, most crypto are heavily correlated with Bitcoin; if Bitcoin goes down, everything goes down. Therefore, it may be tricky to achieve a fully diversified crypto-only portfolio.
2) Using Hedge Mode Trading
Hedge mode trading is a form of contract trading that involves taking both long and short positions on a contract.
In the typical one-way contract trading, traders can only open either a long or short position; if the market moves against them, they run the risk of getting liquidated.
In hedge mode trading, however, this liquidation risk is significantly reduced:
- A trader opens two opposing positions.
- When price moves in one direction, his other (losing) position is eating away at the margin in his P&L for that contract.
- At the same time, his winning position is contributing unrealized gains to that shared P&L.
- This enables the trader to hold a long position for the long term, and at the same time place multiple short positions to profit from downward moves in the short term.
Hedge mode trading is especially suited for mid to advanced traders who:
- Want to reap short-term profits while holding an opposite position for the long term.
- Want to cash in on opportunities when the market bounces.
- Institutional investors who want to hedge their positions for a particular contract with shared P&L.
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In summary, using the hedging mode enables traders to reduce risk using advanced strategies that are not widely available on all crypto exchanges.
However, when applying hedging strategies, traders should take note of the transaction fees and the risks to using leverage that may cut into their earnings.
3) Hedging With Options
Hedging with options in Bitcoin trading allows a trader to purchase a put option contract. A put option gives the holder the right, but not the obligation, to sell an asset at a predetermined price on or before a specific date.
By purchasing a put option, investors can hedge against potential losses due to market fluctuations. For example, if Bitcoin’s price drops, the investor can exercise their option to sell the asset at the predetermined price. The investor is then protected from any losses due to a decrease in the asset’s value.
Traders can also use call options to speculate on the upside potential of a specific cryptocurrency. By purchasing call option contracts, investors are betting that the price of the asset will increase by an agreed-upon amount by a certain date. If they’re correct, they can potentially make a profit from their investment. Hedging with options is a great way to limit losses and potentially increase profits when trading cryptocurrency.
4) Hedging With Futures
While options can be used for speculation and taking advantage of market opportunities, futures are typically used to hedge against potential losses due to market volatility.
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 earning profits when the price increases by taking a long future position.
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.
5) Dollar-Cost Averaging
Dollar cost averaging is an investing strategy that aims to reduce the overall risk of investing by spreading out investment purchases over fixed time intervals, rather than buying all at once.
The idea behind dollar cost averaging is that when you make regular investments in Bitcoin or stocks, you are less likely to buy too much when prices are high and less likely to buy too little when prices are low.
This helps you to reduce the average cost of your shares, balancing out market fluctuations over time. By investing in a systematic and consistent way, dollar cost averaging can help you protect your investments from the risk of large losses due to market volatility.
Additionally, this strategy helps ensure that some money is always invested in the market, allowing you to benefit from any potential long-term growth. With dollar cost averaging, investors can reduce their risk by investing the same amount of money at regular intervals, regardless of stock prices.
The most important element of risk management is to set up a plan for managing risks and to follow it consistently. Risk management plans should include steps to identify, analyze, monitor, and control risks.
Specific strategies can then be developed to address each type of risk such as setting stop losses or taking profits when appropriate.
Additionally, it is important to stay informed about the market fundamentals and other factors that could impact prices.
Finally, risk management plans should include procedures for monitoring progress and adjusting strategies as needed. By taking these steps, investors can better protect themselves from losses due to market volatility and increase their chances of achieving their financial goals.