Introduction
Cryptocurrency aggregate market cap reached $3 trillion during the last Bull Run. The crypto market is expected to print bigger gains in the future. However, many traditional investors and newcomers avoid investing in cryptocurrencies due to associated risks. The below-mentioned Hedging Techniques are useful, efficient, and easy ways to manage crypto risks.
What is Crypto Hedging?
Hedging is a technique to counter or offset trading risks that can happen in a given asset class such as stocks, commodities, or cryptocurrencies. Hedging is a method to mitigate the associated crypto trading risks by the way of investing in products with antagonistic bullish triggers.
Such that when one investment position in the trading portfolio losses momentum, the other one continues to gain it and vice versa. Hedging is sometimes compared with an insurance policy. It is important to note that hedging does not remove trading risks but rather used to reduce them as much as possible.
What is a Crypto Hedging Strategy?
When traders are investing, the best course of action is to prepare a trading strategy that defines their goals, and techniques and guides their decision-making. Risk management is part of every successful trading strategy and hedging strategy is one of its components.
The fundamental principle of hedging is placing opposite bets in a portfolio or inversely proportional positions to continue to gain profits under every market condition. Investors can stabilize the overall value of their crypto trading portfolio by preparing, updating, and implementing hedging strategies.
Types of Crypto Hedging Techniques
Here are some of the most popular hedging techniques used by cryptocurrency investors:
Crypto Derivatives
Futures are crypto trading contracts with predetermined data and prices. Options are also crypto trading contracts with a predetermined price and date but without mandatory obligation to sell or purchase them at expiry.
Investors sell future and purchase options to hedge against the possibility of a price drop in cryptocurrency prices in the spot market and vice versa.
In case, the price of the underlying cryptocurrency does go down, the profits from the futures sales and increase in the price of purchased option contracts offset the overall losses for an investor.
Contract of Difference (CFD)
CFDs or Contract of Difference track the price of an underlying cryptocurrency and pay the difference with the market value to the broker or exchange at the time of sales or purchase. Crypto investors can short the CFD contract for a given crypto coin during a bearish movement and vice versa.
Shorting
Shorting is the process of borrowing a cryptocurrency at lower rates with expectations of a price decline. When the market value drops, shorters sell their positions and buy them back for lower prices to return their loan and make profits. Shorting is one of the most popular and legal methods of hedging during a price downturn.
Perpetual Swap Contract
Perpetual swap contracts track the price of a given cryptocurrency without an expiration date like other derivative contracts such as futures and options. They are used with leveraged trading and grant access to sizable trading positions at small initial margins.
Investors open short positions with perpetual swap contracts when the price of a crypto is expected to decrease and vice versa.
Stablecoins have a standard price such as 1 USD that is not subject to volatility. In case, that the market momentum is going to break, they can hedge their gains by converting their crypto positions into stablecoins. However, stablecoin can only hedge against a price decrease and their value remains static during price appreciation.
Diversification
Investors can always convert their crypto positions between different types of variants available in the market. This process is called crypto diversification and it is one of the most effective ways to avoid losses.
At the same time, investors can also employ asset allocation which is a method of investing in other types of asset classes such as securities, commodities, forex, and derivatives etc to reduce their trading risk by division of multiple positions.
Conclusion
Cryptocurrency hedging focuses on three main tenets of risk management namely opposite market valuation, liquidity research, and diversification. At the same time, they protect cryptocurrency investors from major market risks such as price volatility, regulatory uncertainty, transactional errors, and leveraged positions.
