Cryptocurrencies are incredibly volatile assets. Losing money is as easy as making money. You must learn to control risk in order to be successful in the crypto market. Numerous risk management strategies exist, but the most popular strategy for beginners is hedging.
Hedging is a concept that can be compared to playing both sides so that you always come out on top. Today’s article explains how you can hedge your crypto portfolio as a way to minimize risk and maximize the chance of a positive outcome for your investments.
What is Hedging?
Hedging is a popular risk management strategy that entails taking two inversely-correlated market positions. In crypto, hedging is traditionally found on futures markets where investors open leveraged positions. In this context, hedging boils down to opening one short position and one long position.
The purpose behind hedging is to offset the losses caused in one trade by taking an opposite position in the same asset. The strategy has a good impact during moments where it isn’t exactly clear where the market is headed next.
However, although hedging minimizes losses, it also minimizes profits. Hedging means that you are guaranteed both a loss and a win. The only difference is that the win must be bigger than the loss in order to hedge efficiently.
Hedging is also found outside trading. For example, one might make an investment in Ethereum, a popular dApp ecosystem, and make a similar investment in Solana, another dApp ecosystem. The two investments ensure that you make money in this respective niche even if one ecosystem collapses.
You can also hedge your crypto portfolio by participating in options markets. Trading options means betting on derivatives of underlying assets such as Bitcoin, Ethereum, and other popular crypto assets.
Trading options basically works by purchasing contracts that grant you the right, but not the obligation, to sell or buy an asset at a certain price by a certain date. Sounds confusing? Don’t worry, I’ll explain how options work in more detail in a later section.
How Does Hedging Work in Crypto?
Imagine that Bob has $10,000 to his name and wants to trade Bitcoin. He’s not sure whether the market will rise or fall in value, so he bets on both directions by splitting his capital in half and opening both longs and shorts.
Bitcoin begins to fall in value, and noticing this, Bob decides to close his long position after being in a -5% loss. Bitcoin continued falling, eventually reaching a price drop of 20% from Bob’s entry. Bob decides to close his short and take profit. Bob lost $250 on his long and won $1,000 on his short – profiting $750 in total.
Bob didn’t know what the market would do next. Yet, he still ended up making money. This was made possible purely through hedging. Hedging represents one of the most important ways of controlling risk within a volatile market.
Trading-wise, the most important part about hedging is ensuring that the losses don’t surpass your profits. You can improve your hedging strategies by combining technical analysis and other forms of charting. Knowing which price levels make or break shorts and longs make it easier to know when to close a position.
Types of Hedging Strategies
There’s not just one way to hedge your crypto portfolio. You can employ multiple strategies, including shorting, trading futures, trading options, and much more. Which one you choose depends largely on your goals, skill level, and risk tolerance.
Shorting (Margin Trading)
Shorting is the easiest way to hedge. Shorting an asset involves opening a leveraged trade position that bets on the possibility of an asset falling in value, rather than rising.
You can short by either trading with margin or trading with a futures account. The difference between the two is that futures involve trading derivatives, and not the underlying asset. I’ll talk more about futures in the next section so let’s stick with margin trading.
Margin trading basically involves borrowing funds from the exchange so that you can trade more capital than you have. Exchanges like Binance let you trade up to five times of your initial capital – and possibly more on certain assets.
Shorting with a margin trade is done when you have a portfolio of crypto assets. Having already invested in crypto means that you are basically in a long position – meaning that you’re betting they will increase in value. So to hedge your ‘long,’ you need to have a short position.
So if you have a few Bitcoins, you can hedge your portfolio by opening a short position on Bitcoin. If Bitcoin loses value, you’ll make money with your short. If it doesn’t, you’ll make money through your spot portfolio.
Futures markets involve trading derivatives contracts of cryptocurrencies such as Bitcoin, Ethereum, Solana, and so on. You can buy a certain number of contracts that can be used to represent your stake, or lack of, in a crypto asset. Futures contracts are settled in cash and both sides (shorters and longers) have to pay a funding fee to keep a trading pair up.
Futures markets are used to manage volatility and hedge assets. Most popular futures markets in crypto are perpetual futures markets, meaning that they have no expiry date. This aspect makes futures rather similar to margin trading, except that you have access to way more leverage due to the risks involved.
But the main difference between futures and margin hedging is that the former involves hedging an existing trading position rather than your spot holdings. For example, let’s say I have a leveraged long position for Bitcoin. I might want to hedge my long by opening a new short position. And if I see the market swing in a certain direction, I’ll close the opposite position.
Some futures exchanges like Binance even offer a hedging mode. This mode allows you to hold two opposite positions under the same contract. You can create both a short and a long position at the same time without closing the other position.
Hedging might be even more important in futures markets when an asset has an incredibly high funding rate. You can keep your original position in spite of the funding rate by having another position in the opposite direction open. The funding rate you pay and receive on both positions even out each other, and you get to keep your original position.
Options markets are the most complex market in all of finance. Options contracts give you the right, but not the obligation, to buy or sell an asset during a certain timeframe.
Let’s say there’s a Bitcoin Options contract for the first quarter in which sellers wish to sell the asset for $60,000. The buyers pay a $1,000 premium to have the option to buy Bitcoin for the given price until the end of March.
If Bitcoin reaches $70,000 by the quarter’s end, the buyer obviously wants to buy. He pays the $1,000 premium to exit with $9,000 in profit. But the buyer won’t exercise his right if Bitcoin ends up costing $50,000. He’d not only have an immediate 16% loss but also have to pay the premium.
The seller has a different situation. He is only in profit when the buyer refuses to buy since the seller takes his premium. But when the buyer buys the asset, the seller suffers an opportunity cost as he could have sold the asset for a higher price. Buyers have much more flexibility in options markets because the premium is fixed, but the reward is limitless. Sellers face limitless losses and fixed rewards.
Hedging is a smart way of mitigating risk while ensuring that you almost always end up in profit. The way you hedge depends on the strategy you pick. But most of the time, the effectiveness of your hedge depends largely on your ability to exit your original position and hedging position at the right moment.
The three most popular hedging strategies include shorting, trading with leverage on futures markets, and trading options markets. While margin shorting and futures shorting work almost the same way, options trading is a bit more complicated.
To summarize, hedging involves mitigating the risk of your original position by creating an inversely correlated position. A classic example is having both a long and a short position open. If one fails, the other won’t. But for this to work, the money earned in your successful position must surpass the money lost in your failing trade.
If you want to learn more about risk management, I recommend reading the following articles: