Most cryptocurrency investors prefer a “buy and hold” strategy, hoping that their portfolio will “go to the moon” one day. Crypto Hedge becomes an important concept for investors with crypto exposure who persistently become concerned about market price volatility.
So, when we hedge a crypto investment, we reduce or eliminate (or at least try to) certain risks that could impact our holdings.
Why Hedge Your Crypto Investments?
The cryptocurrency sector provides opportunities like no other asset class and thus, serves as the ideal playing field for experiencing newer all-time highs. With the massive returns generated by crypto assets, it was only a matter of time before investors were warned not to be swayed by optimism and to insure their crypto investments with tried and tested hedging strategies.
The following are some of the downside risks of crypto assets that justify the importance of hedging:
- Cryptocurrencies are not regulated: One idiosyncrasy of crypto assets is that they are largely unregulated. Because of the underlying asset, investments in crypto investments are likely to be riskier than traditional ones. Until now, regulators’ primary focus has been on illegal transactions, which we will discuss in the following point.
- Cryptocurrencies are highly volatile: It has seen a series of sharp rises and falls, with the flagship cryptocurrency Bitcoin losing 50% of its value between April 14 and May 29, 2021, when it peaked at $64,829. While unprecedented large swings in Bitcoin prices can be scary for some investors, it is appealing to some because it allows for “buy the dip”.
- Cryptocurrencies are susceptible to hacks: Cryptocurrencies, as a digital currency, are vulnerable to technical glitches, human error, and hacking. Investors who are alert and prepared can take precautionary measures to safeguard their digital assets.
How can risk hedging strategies be applied to crypto investments? Is hedging completely risk-free? This article will now look at five strategies to hedge crypto investments that are easy to implement.
5 Easy ways to Hedge Crypto
As a trader, you must find ways to protect your investment by finding instruments that minimize risk and hedge volatility.
These are the five following methods to hedge crypto assets:
1. Portfolio Diversification
Portfolio diversification is one of the most effective long-term hedges for a cryptocurrency portfolio. It essentially means buying multiple crypto assets rather than investing all of your funds in a single crypto asset. As a result, the age-old maxim “don’t put all your eggs in one basket” rings true!!
A diverse portfolio strategy works on assets that do not flow in the same current. Hence, by holding uncorrelated assets that give us a negative delta correlation to our current exposure, overall volatility is reduced.
However, it is worth noting that Bitcoin is the matriarch of the altcoins family, and all members share some common characteristics, which is why all cryptocurrencies tend to move in the same direction, following the waves of Bitcoin and Ethereum. As a result, maintaining a fully diversified “crypto-only” portfolio may be difficult.
Traders can also look beyond and outside of the crypto market, as cryptocurrencies have a negative correlation with exchange-traded futures on a variety of traditional assets, which improves portfolio diversification.
2. Short Selling
The most common and straightforward hedging method is to short-sell the cryptocurrency being hedged.
Short selling is an efficient and advanced hedging technique used by traders. Short-selling is the trading practice of selling an asset when it is predicted that its price will fall soon and then repurchasing it at a lower price later. Traders profit from the price difference in this manner.
Although it may sound like a ‘psychic skill’, short selling allows investors to hedge against the downside risk of a long position in the same or a related cryptocurrency. Short-selling cryptocurrencies, in essence, protects 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’, which allows an investor to borrow capital from a broker, whereas some margin trading platforms also allow you to short cryptos with futures contracts.
More on futures contracts & should you use them to hedge crypto or not will be discussed in detail now.
3. Futures Contract
Similar to traditional financial markets, cryptocurrency futures can be used by a trader to “swim against the currents”. Futures contracts are part of many trading instruments known as derivatives, including Contracts for Difference (CFDs), Options, and Swaps.
A futures contract is a financial agreement between two or more parties to trade a specific crypto asset at a predetermined price on a specific date in the future. Because it has its secondary market, you can always sell the futures contract before the specified date.
Thus, a cryptocurrency futures contract helps traders mitigate the risk of falling prices by opening a ‘short position’ when they believe a pullback is due. In secondary markets, they can open a short position, earn some capital, and invest when the price is lower.
Traders benefit from futures when the price rises by taking a ‘long position’ with a futures contract. Cryptocurrency futures allow you to leave your positions open, giving you more room to maximize your profits.
Also read: How Crypto Futures Trading Differs From Spot Crypto Trading?
4. Perpetual Swaps
Perpetual swaps (perpetuals) have recently gained popularity as more and more crypto exchanges begin to offer them. The primary reasons for using this instrument are the same as those for the future.
Perpetual swaps are derivatives that allow you to buy or sell the value of an underlying asset, with the only difference being that you can do so without establishing an expiration date for the position you take.
Perpetual swaps give you “more buying power” than you would have if you traded on the spot market. As a byproduct, they put you in a better position to profit if the price swings in your favor.
Perpetual swaps work with a funding rate mechanism. This mechanism is used to ensure that the price of perpetual contracts does not deviate too far from the price of their underlying asset. And because the perpetual contract price is continually re-aligned with the spot price, such contracts are a preferred hedge strategy.
Before you use perpetual swaps as a hedging strategy, you must first determine the funding rate mechanism and potential returns of your collateral. You should also be aware of the leverage provided by the exchange you choose. This is because some cryptocurrency exchanges offer up to 100x leverage on derivatives.
5. Options
The cryptocurrency space is relatively new and has a limited volume of options. Deribit and Bitmex are the pioneer exchanges that currently support it. Investors have the right, but not the obligation, to buy or sell a specific asset at a predetermined price and date.
Option contracts include “call options” and “put options”. A call option grants you the right to purchase a cryptocurrency, whereas a put option grants you the right to sell a cryptocurrency.
One of the key benefits of using options is the variety of payout profiles. Purchasing put options to hedge means that the downside is limited while the upside is unlimited. The drawback, though, is that they are relatively expensive because of the volatile nature of the market.
The Bottom Line
The article addresses the issue of a cryptocurrency investor who hedges their portfolio’s price risk. With almost everyone else getting wind of crypto investments, it’s easy to fall into the trap of believing that they, too, must catch up. This is not the way to approach cryptocurrency.
Because there are no clear regulations in this market, investors must look for ‘secure cryptos’ while also evaluating the market before investing.
And, unfortunately, the market for cryptocurrency derivatives, such as futures and options, is still in its infancy.
Investing in cryptocurrency may not be risk-free but, again, aren’t there high risks in traditional markets as well?!
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