What is hedging?
Mahi Sall, Advisor, Fintech-Bank Partnerships, Payments and Financial Inclusivity
January 25th, 2023
Mahi Sall is the CEO & Founder of FinXpair, a Berlin-based strategic advisory boutique firm focu[...]
Should You Be Hedging Your Crypto Trading?
Tristram Waye for Bitvo | Aug 18, 2022
What is hedging?
Hedging is a strategy used by all sorts of market participants. It is widely used in commodity trading, hedge fund, and portfolio management strategies. And you can use it for crypto trading. Hedging is an instrument for protecting capital gains and avoiding losses. You can think of it like a synthetic insurance policy or a risk management technique that can be used in a variety of trading contexts.
It is used extensively by commodity producers and consumers to lock in prices for products to be delivered at some point in the future. Options pros or market makers use hedging to offset the call and put options they sell. Equity traders use option-based hedges to protect up and downside of respective positions. They can also use a replacement strategy for existing positions as a sort of hedge. Large portfolio managers may use a variety of instruments, including index futures, and government securities to protect portfolio downside.
See: Expert Tips and Strategies for Crypto Trading
While bitcoin is sometimes described as a hedge, there are various instances where bitcoin exposure itself could benefit from hedging. The origin of hedging as an idea is old, some say dating back to the 1400s. However, for most, the term is often associated with the hedge fund.
Hedging products for bitcoin and ether
For ETH and BTC, one has a variety of ways to hedge.
- You can buy put options to protect yourself from downside. This means taking on an additional position with a different product without selling the one you already have.
- Or you can sell your position and replace it with a call option instead. The call can be used as an asset replacement position where you can retain exposure for a fee. Your downside will be the premium you pay for the option. But if BTC or ETH goes higher while you own the option, you continue to participate until expiry.
- As we discussed in our options piece, it’s important to understand the contract specs of these products in advance. The specs would include the expiry, delivery requirements (cash or crypto), when you can exercise the contract (American or European style options), and any other specifics.
- The same applies to futures. BTC and ETH futures and mini contracts provide a range of ways to use futures for hedging. These include shorting futures or using options on futures. Again the contract specs are critical to understand before getting involved.
- You might also look for listed equities as proxies for various instruments and easier ways for short exposure. Again, not saying you should do this, but it’s just another way to use an instrument for hedging specific exposure. For example, MicroStrategy could be a good proxy for Bitcoin, given its significant stake. Or you could look at other listed crypto entities like Coinbase.
See: How to get into angel investing with ‘no’ money
…but hedging isn’t free
There are opportunity costs. If you protect the downside of your position and it goes higher, you give some of that up. This is a form of opportunity cost. The premium you pay for an option contract is a cost. There is the potential for slippage. And when you use sophisticated options trading strategies, there are other risks. If you are using futures, there are margin, execution, and opportunity costs. So any time you are thinking about hedging, it’s not just the protection, but the cost of that protection in terms of opportunity cost, slippage and other tangible costs.
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