Trading in the cryptocurrency market is a risky business. Here is the step-by-step guide to hedge cryptocurrency to protect yourself against that risk.
23 October 2019, AtoZMarkets – As cryptocurrencies have gained attention, traders have started to find ways to protect their investments from risk. There are a variety of reasons that cryptocurrencies like bitcoin (BTC), are risky. However, to avoid the Cryptocurrency trading risks, a trader should the process of hedging in cryptocurrency.
What is Cryptocurrency Hedging?
The cryptocurrency hedging is the method that involves strategically opening trades to offset the losing position by changes to the value of the other position.
Normally a trader should reduce the trading position or the closed position on an uncertain situation to mitigate the risk. However, hedging is a useful strategy for traders to maintain the original cryptocurrency holding with a neutral exposure.
The cryptocurrency market is one of the newest types of investments, which consists of a high level of risks and returns. The main investors in the cryptocurrency markets are high-risk tolerance. From the very beginning, they have demonstrated a limited demand for hedging. As the market develops, the hedging mechanisms are evolving, consisting of classical tools and unique methods of blockchain.
Read More: How crypto arbitrage bot works?
Things to consider to Hedge Crypto Trading Risks
In order to Hedge Crypto Trading Risks, there are several things to consider first:
Diversification is a common way of mitigating cryptocurrency trading risk in the market. Diversification is all about maintaining a healthy mix. In the stock market, there are a multitude of industries. So it is easier to pick offsetting stocks according to the industries they operate in. In the cryptocurrency market, most of the trading pairs are very volatile and the market generally trends together daily.
The diversification strategy for hedging the risk builds the foundation of a portfolio on most of the traded coins. Bitcoin, Ethereum and Ripple generally are the least volatile and perfect for hedging against other riskier coins.
The second tip is to make an account on an exchange that allows to hold money in fiat currency with the cryptocurrencies. This allows to transfer of money in between and helps to reduce from getting stuck in a bind if a major crash occurs. This also allows quickly to take advantage of optimal exchange rates with the proportion of the investment.
#3 Use of options and futures
This is called crypto derivatives. This requires more capital, more risk, and advanced trading knowledge. Sites like Hedgy, Bitserve, or Coinapult allows to hedge cryptocurrencies by buying options or futures contracts.
Types of Hedging Techniques
Short-selling is the practice of taking a position to sell an asset. The trader should believe that its value will fall to buy back for a lower price and making a profit from the difference. Short-selling is a common hedge of bitcoin against a long exposure.
The traditional method of short-selling involves borrowing a cryptocurrency from a broker or third party and selling it on the open market. There are a few cryptocurrency exchanges that allow short-selling. But It is often difficult to find a third party that is willing to lend the assets.
Even the lender is found, they would recall their asset at any time
For example, if we borrowed a bitcoin to short-sell when the market price was $8500. But instead of falling in value, the price increased to $10,500. Then we bought the bitcoin and taken a $2000 loss.
Hedging through diversification happens by the gradual fixation of profits and replacement of the assets’ portfolio. The assets should have an inverse correlation to the specific cryptocurrency price.
As an example, the DigixDAO coin (DGD), has an inverse relation with Bitcoin.
#3 Margin Trading
Margin trading carries out at the expense of borrowed assets from the trading platform. By providing the site with security, the trader can borrow from the trading platform in Bitcoins and sell them. This will make a profit if the Bitcoin price drops, which allows using margin trading as a hedging instrument. This system is suitable for the crypto investors who are afraid of a drawdown of the portfolio and it works well with the Bitcoin. The expected price drop may open a new short position, allowing reducing losses while the investor gradually sells his cryptocurrency for USD.
In addition, this strategy allows to sell the Bitcoins volume gradually and do not bring all to the stock exchanges. Most large exchanges have functional margin trading options. For example, tiquid provides leverage with a factor of up to 100x.
#4 Conditional orders
This method of hedging allows calculating the maximum possible percentage of a drawdown of a portfolio with maximum accuracy. However, this system has a significant drawback, as it requires the storage of assets in the account of the platform.
By knowing the current price of an asset, a trader can set the maximum allowable drawdown price to establish the conditional order. Then it will sell the assets determined by the investor in the market when the specified asset falls to the selected level.
Despite ordinary trading platforms, the cryptocurrency market is in its beginning and still has relatively low liquidity that often makes the hedging difficult. In addition, cryptocurrencies are not legalized in most countries of the world & not all sites that provide derivatives trading have licenses.
#5 Hedging with Options
Options in cryptocurrency space are new and limited. Deribit & Bitmex is currently offering the opportunity. As they are very experienced, they explained the basic mechanism of options here.
Hedging with options is complicated and there are several to build the payoff. However, there is a straightforward way to hedge out the downside risk.
- At first, an account with the exchange is required.
- Then, based on the current price of bitcoin (BTC), the expected hedging period is required.
For example, if BTC is at 6432 and the trader wants to hold it until the end of the month. After that, at the 6500 put option pricing for the end of the current month. If there is no match on the time- frame, the trader needs to wait until it covers the timeframe.
- For the chosen ITM put option price check its current price and calculate the amount needs to deposit.
- Deposit the funds into the exchange.
- Purchase the put option and hold it until expiration.
#6 Perpetual Swaps
Perpetual swaps have grown in popularity and crypto exchanges have started to offer them.
The first crypto exchange to have perpetual is the Bitmex, where they have a detailed process explained. Some of the concepts of calculating the funding rate could be complicated to use. In this system, a high-level understanding is needed as it will calculate the funding rate.
Ultimately, the strategies for using these tools are depended on an individual solution to the hedging dilemma. However, It isn’t easy to sell a significant amount of cryptocurrencies without spreading market fear. Hence an alternative is to put hedges in place to reduce the overall exposure over a longer period of time.