Crypto Hedging: What Is It & How Does It Work

TL;DR

• Crypto hedging is like buying insurance for your crypto investments. 
• It reduces risk by taking positions that move in the opposite direction of your main holdings. 
• There are different ways to hedge, like futures contracts or options trading, but each has its own risks and costs. 
• You must consider your risk tolerance and investment goals before deciding if hedging is right for you.

Who doesn’t like to minimize potential risks while maximizing profits? Typically, this is easier said than done. Volatility needs to be accounted for. It is crucial for investors and traders to strategically minimize associated risks as a way of protecting gains and preventing steep losses. There are multiple tools and strategies that you can follow to do so. Some of them include Stop Loss, Take Profits and Hedging. 

In this article, we try to dig deep into the complex concept of hedging in the crypto space. 

What Does Hedging Mean in Crypto?

Hedging generally means making an investment to offset the potential risk. In crypto, it specifically refers to opening two or more positions that are adversely related in simple terms that can grow in opposite directions. It is like buying insurance to safeguard yourself from unexpected losses. Though it safeguards investors in a volatile market, it also limits potential profits.

How to Hedge Crypto

Hedging in crypto involves taking calculated positions that offset potential losses in your existing holdings. Here’s a breakdown of 5 popular hedging techniques:

[1] Futures Contracts: Imagine locking in a specific price for buying or selling a cryptocurrency at a predetermined future date. This is the essence of futures contracts. By entering a futures contract opposite your current position, you can potentially profit if the market moves against you. Let’s say you own Bitcoin and are concerned about a price drop. You can buy a Bitcoin futures contract. If the price falls, your futures contract will gain value, offsetting the loss on your Bitcoin holdings.

[2] Options Trading: Options contracts offer you the right, but not the obligation, to buy or sell a cryptocurrency at a specific price by a certain date. This flexibility allows for more targeted hedging strategies. For example, a Put Option grants you the right to sell Bitcoin at a predetermined price (strike price) by a specific expiry date. If the price plummets, you can exercise the option and sell your Bitcoin at the higher strike price, minimizing your losses.

[3] Short Selling (for advanced users): This technique involves borrowing cryptocurrency from a broker and selling it immediately, hoping to repurchase it later at a lower price and return it to the broker, pocketing the difference. While short selling can be lucrative in a falling market, it comes with significant risks. If the price goes up instead, your potential losses are theoretically unlimited. Due to its complexity, short selling is generally recommended for experienced traders.

[4] Portfolio Diversification: Don’t put all your eggs in one basket! Spreading your investments across various cryptocurrencies with different risk profiles can act as a natural hedge. By including both established coins and promising new projects, you can mitigate the impact of a single cryptocurrency’s price swings on your overall portfolio.

[5] Stablecoin Integration: Stablecoins, cryptocurrencies pegged to a stable asset like the US dollar, offer a measure of stability in the volatile crypto market. Allocating a portion of your portfolio to stablecoins can act as a buffer during market downturns.

Examples of Crypto Hedging Strategies:

Though, there are multiple ways to crypto hedging, let’s discuss two practical examples of how you can minimize and protect yourself from potential loss to some extent.

Let’s say you firmly believe in Bitcoin’s long-term potential but are worried about a short-term price correction. You can buy Bitcoin and simultaneously buy a Bitcoin futures contract expiring a few months out. If the price dips in the short term, your futures contract will gain value, compensating for the decline in your Bitcoin holdings.

For another example, let’s assume you’re invested in Ethereum but want to hedge against a potential price drop exceeding a specific threshold. You can purchase Ethereum Put Options with a strike price slightly below your desired protection level. If the price plummets beyond the strike price, you can exercise the option and sell your Ethereum at a predetermined price, minimizing your losses.

Benefits of Crypto Hedging: Why It Makes Sense

• Reduced Risk: Hedging strategies can significantly decrease the risk of substantial losses during market downturns.
  
• Peace of Mind: Knowing you have a safety net in place allows you to participate in the market with greater confidence.
  
• Profit Potential: Hedging can be used not just to protect against losses but also to generate profits from market movements.
  
• Strategic Flexibility: A variety of hedging techniques cater to different risk tolerances and investment goals giving you the flexibility to enter and exit different options with market movements and potentially providing crypto arbitrage opportunities.

Navigating the Challenges and Risks of Crypto Hedging

While crypto hedging instruments like futures and options contracts create an extra layer of protection against market volatility and potential losses, it is not all sunshine and roses, it comes with its own set of challenges and risks. Some of them are high fees, complex strategies, and reduced professional gains. 

High fees can eat into your potential profits, and some hedging strategies, particularly short selling, require a deep understanding of the market. Otherwise, you may be exposing yourself to an even greater level of risk. Furthermore, hedging requires opening an adversely correlated position that reduces overall potential gains. As such, finding the right balance is easier said than done. If you were to hedge 100%, you would effectively profit nothing. Thus, it is important before making a decision you consider all the potential factors. 

Conclusion

The cryptocurrency market offers immense potential, but its volatility can be daunting. Hedging strategies can be powerful tools for mitigating risk and protecting your investments. However, it’s crucial to understand the different techniques, their associated costs and risks, and how they align with your investment goals. By strategically incorporating hedging into your crypto portfolio management, you can navigate the market with greater confidence and potentially maximize your profits. However, it is important you constantly refine your approach and keep learning from your mistakes.

Enhance your trading strategy with our Rubic’s DeFi insights and resources. Start making more informed decisions in the crypto market today.

FAQs

What is hedging for beginners?

Think of hedging as an insurance policy for your crypto holdings. It involves taking calculated positions to offset potential losses if the market goes against you. Crypto hedging is a popular risk management strategy to minimize your risk.

How do you make money from hedging?

Hedging isn’t necessarily about directly making money; it’s about protecting your existing holdings. However, some hedging strategies, like using option contracts, can generate profits if the market moves in a specific direction.

Is hedging a good strategy in cryptocurrency?

Hedging can be a valuable tool for managing risk in the volatile crypto market. However, it’s not without its challenges. Whether or not hedging is right for you depends on your risk tolerance and investment goals. If you’re a trader with a high risk tolerance hedging may not be the right decision for you as it may restrict your profit s too.

How do you hedge a short crypto position?

Hedging a short position (borrowing and selling crypto) can be tricky. One approach is to buy a Put Option contract on the same cryptocurrency. If the price goes up, the Put Option will increase in value, offsetting some of the losses from your short position.