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August 24, 2022

What is Hedging? Top Four Crypto Hedging Strategies

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Crypto trading is becoming increasingly popular for investments, but it can be risky and the crypto market’s volatile nature can be off-putting, especially to new traders looking to get started. More traders are using hedging strategies to limit the risk of any one trade. To start hedging, you need a lowdown of the latest techniques and a good strategy. Read on and we’ll point you in the right direction.

But first, what exactly is hedging?

What is hedging?

Hedging has been a financial market strategy for a long time. Hedging in crypto aims to reduce the risk caused by adverse price movements in a cryptocurrency. Hedging strategies minimize the chance of your assets losing value by limiting your loss to a known amount— this way you’re not losing significant value across your entire portfolio. Hedging protects your assets, however, it also limits the potential gains from an investment. Additionally, hedging requires you to pay money in fees for the protection it provides since your portfolio will likely be spread across a greater number of assets and trades.

Before you start cryptocurrency hedging, you need to follow these three important steps:

Conduct research. Before you make any investment decisions, you should learn as much as you can about crypto markets and possible hedging strategies that are right for you.

Pick a strategy. Explore and choose the right hedging strategy for your needs. Read below for our top four strategies to help you get started.

Choose a platform to start hedging. Many exchanges offer hedging, but make sure you trust the platform and it has the features and functions you’re looking for before committing to any hedging positions.

Here are three core techniques to remember when hedging:

Diversification. You can open multiple positions in ETH, BTC, and many other tokens to create a well-diversified portfolio made up of derivatives. Diversification is one of the best techniques for money management and it’s easy.

Liquidity assessment. Assess a new token’s liquidity to determine market integrity, market fluidity, and transaction speed. This will allow you to exchange assets for cash without too much slippage.

Opposite position. You should enter a hedging position that’s the opposite of its current position. If you forecast an increase in a token’s price, you should enter a long position (aiming for a price increase from a given point).

Top four types of hedging strategies

There are many hedging strategies you can use to reduce the risk to your crypto portfolio. We’ve chosen the safest strategies that’ll help you invest in crypto with ease. You can hedge crypto with the following strategies.

Using derivatives for hedging

Hedging with derivatives. Derivatives allow you to invest in crypto without actually holding the asset. There are several types of crypto derivatives available and they are one of the most common hedging strategies. Futures, forward contracts, and options are the derivatives that'll likely be most useful to you when you’re planning your hedging strategy as they help to mitigate risk in your portfolio.

Hedging with futures. Futures are a type of contract where you and another party agree to trade an asset at a predetermined price on a specific date in the future. With futures, you can speculate on market direction. You can hedge crypto investments with futures contracts or lock in your profits. Hedging futures are ideal if you want to hedge your exposure in the market for a decent price. Additionally, futures can be sold before the agreed-upon date, which can release your liquidity.

Hedging with forward contracts. Forward hedging contracts, commonly known as over-the-counter transactions, are agreements between you and another party to buy or sell an asset based on a set of predetermined conditions. Together, you negotiate the contract terms and then the forward contract is concluded outside of exchange trading. Forward contracts are different from futures contracts, as the details and contracts of futures are standardized, whereas forward contracts are tailored to both of your needs.

Hedging with options. Hedging options allow you to buy and sell an underlying asset at a specific price or before a set date. There’s no obligation when you use options. Using options to hedge limits potential downward losses in a declining market, and provides opportunity for unlimited upside. A call option lets you buy a token, while a put option lets you sell. There is hedging risk with options however. Long-term options can be expensive, and short-term options can expire before they provide you with the desired hedging protection.

Pairs trading

Pairs trading is one of the simplest hedging techniques you can use. You pick two pairs and start long and short trades simultaneously. At first, the trades will be evened out. You can cut off the underperforming trade when they start diverging to maximize your profits on the successful pair.

High market-cap crypto pairs such as ETH/USDT and BTC/USDT are highly liquid, and these pairs are unlikely to experience as much price volatility as lower market-cap coins for example. High liquidity tokens can be a relatively safer option with potential for profit during marketing downturns as well.

Stablecoins

Stablecoins are tokens that maintain a stable value. They’re usually valued 1:1 with the US dollar. Stablecoins help to hedge against the volatility of the crypto market. No matter if the market value drops or rises, the value of stablecoins remains largely the same. Stablecoins act as a safety net for you if the market is particularly unsteady at the time of investment.

If a token is valued high but there’s a drop forecasted, you can protect your portfolio from this volatility and move a proportion of your assets to a stablecoin. Once the market has calmed down, you can trade the stablecoins back to a token of your choice. This way, you’ll be protected from potential losses when a crypto asset falls in value.

The three most common stablecoins are USDT, USDC, and DAI.

Crypto portfolio allocation

This hedging strategy involves identifying the percentage of crypto in your overall investments. Then you choose a variety of tokens that match your risk appetite. Diversifying your portfolio is important to hedge against the risks involved. It can take time to create a combination of tokens that matches your needs and the level of risk you’re willing to take. For instance, the bigger the share of high-risk assets in your portfolio, the higher your potential gains or losses will be. Spreading your investments across different tokens will diversify your holdings and even out risks. A varied portfolio is a great way to hedge against potentially losing a significant value of your portfolio.

Benefits of hedging (and the drawbacks)

As you can see, there’s a range of strategies you can choose for hedging risks in your investments, but there are pros and cons to hedging you need to be aware of.

Some of the benefits of hedging include:

Securing profit. If you’ve already earned profit from the market rising, it can be secured by hedging your position and keeping your gains safe from potential losses.

Protecting from loss. If the market goes against a position you’ve hedged, with a CFD (contract for difference) for example, your hedge position will cover some of the loss so you won’t lose 100% of the value of your initial trade.

Withstanding volatility. Hedging helps you secure trading positions and your overall portfolio and combat market volatility.

Greater exposure. If risks are mitigated through hedging, you can increase the exploration for a trade since you’ll have the confidence of knowing all your funds' potential gains won’t be lost.

Simultaneous short and long-term gains. Hedging allows you to have two seemingly contradictory trades open at one time, such as a long and a short trade for example, meaning you can take advantage of price movement in both directions and quickly adjust your strategy with market changes.

Some of the potential drawbacks of hedging include:

Potential reduction in gains. Hedging helps to protect your portfolio from significant losses, but this is balanced against the potential for significant windfalls from sudden market volatility such price surges.

Lose more from the spread. If you’re going long and shorting one pair and its value surges, you’re potential profit will be offset by your short position. Remember, hedging is all about protecting against market risks.

Hedging needs to be balanced with short-term strategies. Hedging is a method to protect your overall portfolio from losses, but if you overfocus on hedging you may miss out on potential short-term opportunities. You need to balance your hedging strategy with your short-term trades to make sure you’re benefiting from potential market gains while not over exposing your portfolio.

Hedging is coming to bitoftrade soon

Hedging is a great way to protect your overall portfolio from market volatility and the risks involved with trades—and crypto markets can be highly volatile at time. We can’t stress the importance of conducting thorough research into trading and the crypto market before hedging a position. This guide is a useful start in your hedging journey, but we recommend you do your own research as well as you develop a strategy that’s right for you.

At bitoftrade, we’ve launched our new DEX trading platform complete with advanced features including stop-loss, limit, and leverage orders, and combined them with a seamless user experience so you can get the most out of your crypto trades.

Expect to see hedging added to the bitoftrade platform soon.

Visit our website to start trading on bitoftrade.

Exciting developments and updates are coming to bitoftrade Be the first to know.

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