The crypto markets are rife with risks such as investing and trading errors. Protecting your capital is crucial before speculating and betting on your next investment. There are many tools and techniques to mitigate the risks out there when you are exposed to adverse elements such as unfavourable market condition, Fomo and Fud. One of those techniques for protecting capital is gaining traction among crypto traders and investors of all kinds. Today we are going to discuss Cryptocurrency hedging and why you should consider using its help, given its popular nature.
What is Cryptocurrency Hedging?
Hedging is a method of strategically opening new positions to protect your already active position form adverse and unpredictable market movements.
Hedging involves holding one or more positions to deal with any upcoming loss from the first position and counterbalancing it with gains from the other.
Having a high-risk tolerance is fundamental to investing and in this nascent crypto market. Traders and investors need to capitalize on almost anything that could prove beneficial in this ever-evolving industry. Cryptocurrency hedging can be a useful strategy for traders to preserve their crypto holdings with a neutral exposure to risk. Crypto hedging, however, won’t prevent an adverse condition from occurring, but it can help you as a precedent to protect yourself should such a thing take place.
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So, how does it work?
Hedging is not used for making profits, but instead, it is used to minimise losses that may incur if the markets move against your active position. Having a favourable hedging strategy can help you minimize losses whilst trading or investing. It is basically a transfer of risk any insurance policies to purchase.
Hedging can be used in Spot and Futures markets which enable the user to purchase a contract, security or a digital asset at a specific price the payment of which is deferred to a later date.
Hedging consists of many trading opportunities but should be used with caution for risk-averse trading. You can go with strategies such as short selling, or hedging with derivatives and futures for risk-averse trading. Hedging can be a really good strategy if something unexpected contradicts your expectations while placing trades.
Short-Selling
Simply put, Short-selling is a strategic move to protect your assets that are on the line. One can sell to open another position and buy back later at a lower price than it was sold at, thus, keeping the price differential as gain. You can use a leverage of up to 5x for this action and sustain yourself if something adverse happens.
For instance, if you hold a certain amount of ETH in your portfolio and want to hedge against a downturn risk, you could open a new margin trade by borrowing, let’s say 1 BTC and selling it soon after for a price of $5000. If the price drops, one could buy back 1 BTC at a lower price, say, at $4800 and then repay the margin lending you owe. The $200 will cover your loss from your BTC holding. In order to succeed in Short-Selling, you should consider the margin interest and transaction fees as defining factors for your trades. A careful calculation prior to it can help you weigh in the risk and rewards.
Derivatives
A derivative is a security that derives its value from other similar assets; here, cryptocurrencies. The most common form of crypto derivatives is bitcoin futures which are used by almost every other crypto trader. Derivatives are ways by which a trader can mitigate the risks associated with crypto volatility. Using this type of trading, in particular, has reduced the risk of exposure for crypto traders and corporations as they are meant to aid investors to protect their investment portfolio from losses.
The underlying assets that are used in derivatives are fiat and cryptocurrencies, commodities, bonds, stocks, market indexes and interest rates. Derivatives are traded either on exchanges, Over-the-Counter (OTC) or customer-to-customer (C2C), which is different in regulation and trading. Active traders often use both methods for derivatives trading to potentiate their profits and prevent sudden losses wherein perpetual swaps are the most sought product for derivatives trading. Futures and options are two other popular modes of trading derivatives.
Hedging has the following advantages:
Limiting losses
When you strategically place your positions across assets and markets, there are high chances that you will gain from one or the other.
Saving time
You can save a lot of time if you are unsure of the market sentiment that can sway at any given moment. You hedge will be your perfect getaway as you can put your loss and the gain from another position in equilibrium.
Increasing liquidity
Through hedging, you can take advantage of optimal exchange prices keeping your investment proportionate. Open an account on an exchange that allows fiat to crypto trading so that you can freely move money in between to prevent losses if a major market crash occurs.
Disadvantages of Hedging
Limits the profits
Perhaps the major disadvantage of hedging could be the limiting of profits of the individuals practising it.
Limited cryptocurrencies to choose from
One can only choose major coins such as Bitcoin, Ethereum, XRP and others.
Affects short-term trades
Short-term traders can see a downside here as the markets are moving with agility at all moments. A sudden depreciation can affect thor trades due to the volatility. To carry out hedging successfully, one must initiate their trades with better skills and experience to avoid losses in uncertain markets.
Are there any alternatives to hedging?
Yes, there are and you can use a number of considerable risk-mitigation strategies so that you can make optimum profits without having to lose anything. You can follow crypto arbitrage, select a few trading styles or open favourable positions to prevent abrupt investment losses.
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