The lucrative profits that bitcoin has offered since the start of 2017 are hard to resist. However, the wild price of the cryptocurrency left many investors asking how can they hedge Bitcoin volatility?
17 October, AtoZForex – Cryptocurrencies are rising at staggering rates, which is piquing the interest of any investor who has not yet trade cryptocurrencies.
However, even the most stable of these digital assets, Bitcoin, is still infamously known for its volatility, so the one million dollar question is: how can you hedge Bitcoin volatility?
How to Hedge Bitcoin Volatility
A flash crash that momentarily erased 99.97% of Ethereum value on June 21 was nothing new to the world of cryptocurrencies. Ethereum’s big brother, Bitcoin, had taken investors on a rollercoaster ride from $1,200 in November 2013 down to a little over $200 in March 2015. The most famous digital currency then moved through powerful ups and severe downs until it reached about $5,200 today.
However, since bitcoin’s ups appear to overpower the downs, investors who once feared the cryptocurrency now want a way in. The main goal these investors seek is to successfully hedge against bitcoin volatility, while still making profits.
Does traditional hedging works on Bitcoin?
Traditionally, investors use hedge fund strategies to cut down risks in established financial markets. One of the common methods to reduce risks is buying call options. A call option basically gives the right, but not the obligation, to buy an asset at a specific price on a particular date.
When a call option expires, the buyer will make a profit if the price of the underlying asset moved higher. On the other hand, if the price declined, the buyer only loses a fee or a premium that the seller keeps.
However, in the bitcoin world, call options are yet to become readily available. Despite a few attempts, no firm managed to steadily provide a call option service for the cryptocurrency traders.
Several other methods of dodging financial risks have a limited usage in the bitcoin market. More often than not, the cryptocurrency proves that digging deep into details of the fundamental analysis, adoption levels, and trading strategies does not cross off the volatility.
How else can you hedge Bitcoin volatility?
Yet, one remaining tool shows enough promise. This tool comes in the form of an investment strategy that hedge funds developed over 50 years ago. By observing price trends over a certain period of time, often ranging from one month to one year, one can simply ride the ongoing trend. Traders commonly refer to this strategy as trend following.
Economic research showed that the trend-following strategy yields results similar to call options when used on a variety of assets. Applying the same strategy on bitcoin also gives results that mirror call options.
When tested, the trend-following strategy generated profits over a specific period of time that matched the gain bitcoin had over the same period of time. However, losses suffered when following this strategy were five times smaller than the decline in bitcoin’s price.
Nonetheless, just like any trading strategy, there are a few downsides. The trend-following strategy requires a level of dedication to follow the market on a daily basis. Another downside comes in the form of a delayed reaction to positive price movements.
Lastly, while this strategy appears to reduce the risk of trading bitcoin, it does not eliminate it. Despite the reduced risk this strategy offers, intense movements that the bitcoin price occasionally exhibits can still lead to sharp losses.
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