If you are in the crypto space, you already know that cryptocurrencies can be a risky investment. Unfortunately, market downturns are a part of the game, and as a trader, it is essential to protect your capital from crypto-related risks. Hedging is one of the methods that can save your assets from volatility.
Via the concept of crypto hedging, traders open positions opposing market trends to overcome the risks and impacts of volatile market swings.
But to understand crypto hedging properly, one needs to understand risks related to cryptocurrencies and how they can destroy a position even when the charting is perfect.
This article will go through everything a beginner needs to know about crypto hedging and why it is helpful for a trader to hedge.
What is hedging?
In simple words, hedging is a trade initiated to reduce the risks of conflicting price trends seen in a particular asset. In addition, crypto hedging enables a trader to open more than one concurrent bet, minimizing the risks of drastic losses.
The concept of hedging has been around for decades. It is being used not just in cryptocurrencies but in every major segment of finance. Hedging allows an investor to secure a stable revenue out of their investments even during undesirable market conditions.
Thus, if correctly applied, hedging can eliminate the uncertainty of investing in a cryptocurrency to a greater extent. But while it limits the potential losses, crypto hedging has some downsides too.
Hedging can protect an investor's asset from adverse market fluctuations, but it will also limit the potential profits that the investor could have gotten. But many swing traders and investors with substantial capital invested might agree to this risk-averse strategy rather than losing money in wrong trades. Hedging thus acts as insurance of a trade, which will be invoked if gone wrong.
Why is hedging important in crypto?
Volatility
For the most part, cryptocurrencies are volatile assets; they are unregulated and, at times, unstable. Therefore, even after charting on an asset perfectly and opening a trade accordingly, you might have to experience trend reversal in the opposite (than expected) direction.
Stop loss is essential, but can they save you from heavy losses?
As mentioned above, cryptocurrencies are fundamentally volatile assets, and even if the price action is going as planned, there could be stop hunting. Stop hunting is a strategy that tries to force some market participants out of their positions by pushing the price of an asset to a level where many have chosen to set stop-loss orders.
Bitcoin dominance
Altcoins follow Bitcoin's price actions, i.e., if Bitcoin dumps, altcoins generally will, too, and if Bitcoin pumps, the altcoin will too. This is because Bitcoin constitutes more than 40% of the crypto space and hence the most dominating cryptocurrency. But if a coin is nearing a breakout or has broken out due to some recent developments and Bitcoin dumps, that breakout would abruptly turn into a fakeout.
Top crypto hedging strategies
As a trader, below are the four most popular strategies that can be used for crypto hedging against the market to secure your holdings.
1. Short selling
In short selling, traders take a position to short an asset when they believe that their spot holding will temporarily(or for an indefinite amount of time) fall in value. With short selling, traders can also sell their spot holdings and buy back when the price is lower, securing the gains and thus securing more buying power.
In other words, short selling allows investors to hedge against the downside risk of a long position in the same cryptocurrency or a related one. Basically, short selling in cryptocurrencies protects against long exposure. However, shorting might bring complexity to margin trading since increased borrowing power could raise your liquidation price.
2. Futures
Future is essentially a contract between two or more parties that agrees to buy or sell an asset in the future at a pre-determined and agreed-upon time. In secondary markets, the futures contract can be sold before the agreed-upon date. Futures contracts are part of many trading instruments known as derivatives, including Contracts for Difference (CFDs), Options, and Swaps.
Investors can open a short position when they think a pullback is due; in secondary markets, they can open a short position, earn some capital and invest when the price is lower.
Cryptocurrency futures allow users to leave their position open, maximizing their profits from your crypto investments.
Futures contracts can be a good hedge for investments or lock your profits in a volatile market such as cryptocurrency. These are ideal for investors who want to hedge their exposure in the crypto market for a reasonable period.
3. Perpetual swaps
Perpetual swap also falls into the category of derivatives that allows an investor to buy or sell(long or short) the value of an underlying asset without the need for an expiration period for the position (long/short). In perpetual swaps, investors can exit at any time they want.
With perpetual swaps, investors can get more buying power than they have; hence it is easier to take advantage of the price fluctuations while holding your position in the spot. Additionally, perpetual swaps operate on a funding rate mechanism that rebates to continue holding the position. The fee is deducted from the margin provided by the investor.
This strategy has gained traction in the crypto market since it enables traders to leverage positions without an expiration date. Perpetual swaps have proven to be a great aid to retailers who want to increase their buying power. The perpetual swap also incentivizes traders to long the asset when the index price is bearish. The funding rates are usually designed to ensure price stability.
4. Options
Options also fall into the category of derivatives in crypto. They allow investors to bet on the underlying asset's increase, decrease, or volatility without actually buying or selling it. With options, investors can hedge in cryptocurrencies by limiting downward losses in a declining market.
The 'put' option means that an investor is betting on a price drop, and it will increase in value when the underlying asset declines below the option's exercise price. Thus the put option results in a significant level of leveraged hedge protection at a relatively lower cost.
Hedging is not 100% risk-free, like any other strategy in the finance sector, and it does not guarantee the success of your investment. It can turn in a profit and allow a lower buying price, but it can also lead to significant losses if not applied properly at the right time.
But for a large portfolio, the benefits of hedging outweigh the benefit of not hedging, and therefore exercising crypto hedging, especially for swing traders, is advisable.