8 Ways To Hedge Against Volatility in Cryptocurrency Trading

While volatility or high variability in Bitcoin prices isn’t as notorious as it used to be couple years ago, it’s high compared to other assets like stocks. This week on January 17, Bitcoin’s volatility just rose to highest levels since November last year. And volatility is a huge and regular concern for new and small cap coins; although volatility is not necessarily a bad thing because many many swing and day traders trade volatility in cryptocurrency because it presents the opportunity to garner huge profits than even in forex trading. They more than love it.  

Nevertheless, volatility may not be admirable for some institutional investors or some other investors and traders who prefer the constancy and predictability of the value of their assets and/or who crypto trading isn’t their day-to-day hustle. So this guide may help. Meet hedging of crypto, which is not at all a new practice. It’s been in stocks and commodity trading for many years now. But today, let us look at how it is being done in cryptocurrencies.       

But first. Hedging of an asset basically means taking some action against the risk of incurring losses in an asset, which usually happens due to reduction in prices. These days, there are different ways through which a cryptocurrency trader can hedge against the risk of incurring losses. In other words, when you hedge, you are not looking at getting a profit, but maintaining the value of your assets. You cannot get a considerable return out of it but will maintain a stable value of the asset over undesirable market conditions.  

Compared to normal/ordinary selling, hedging of cryptocurrencies can be more cost efficient, allow one to enter and exit market, and one can take advantage of leverage or margin trading to maintain lesser of their funds on an exchange. Here are some methods of hedging cryptocurrencies to reduce the risk that comes with it.  

Short selling

Short-selling means selling an asset now and buying it back later at a lower price and keeping the difference as the gain. Ideally, you would be borrowing crypto to sell them at the currently higher USD price and then when the price of that crypto goes down, you can buy back the crypto at that lower price in order to refund the previously borrowed crypto. You keep the difference in USD value.  

Short selling is supported on a number of many exchanges including OKEx, Binance, BitMex, Poloniex, and Bitfinex and is advantageous because it allows traders and investors to continue retaining or hodling their crypto; or rather, it is suitable to traders or investors who do not want to sell their crypto because of the future prospects on the assets.

Since many exchanges which support short selling allow you to borrow crypto and trade it on margins, you get to retain lesser amount of your funds on the exchange while trading. Some crypto exchanges will lend you crypto and others USD in order to margin trade.

However, you might need to deposit USD to act as collateral in order to maintain your leverage. The amount of USD margin to initially deposit on the exchange before you take leverage will depend on the margin ratio. For instance, a margin ratio of 1:1 requires you to deposit an equivalent value of USD to that value of the BTC or other crypto you want to margin trade.  

Unfortunately, it can be more expensive to short sell for a long period because the added cost of borrowing in addition to the transaction cost. In addition, shorting carries higher margin than other shorting methods. Further, there is a risk that short selling is ineffective. For instance, if you are shorting cryptocurrency on one exchange but you normally use a different one, if for some reason the cryptocurrency price does not go down on the exchange you are shorting while the prices go down on the exchange you normally use, short selling may not be effective. Some of the reasons that can cause these differences in prices are exchange default risk, airdrops and forks. You would also need to monitor your trades in order to ensure that you do not get liquidated once margin call is violated.

CFD or contract for difference, which are cryptocurrency derivatives sold on online brokerages such as eToro, CMC Markets or FXCM. These are more suitable for traders who want to trade on these other traditional online brokerages as opposed to trading on digital asset exchanges. These brokerages pay the profits in fiat currency. Otherwise, the process on the both types of exchanges is same.

Futures

Futures is a financial contract between seller and buyer to sell or buy a given amount of asset at a predetermined price and date. Some exchanges offer different options in terms of time for closure – one week, biweekly etc.

Ideally, a crypto futures is crypto derivative product that allows traders to bet or speculate price movements at future date and to get profit or loss so the trader does not need to own the underlying asset in order to bet or speculate on the price movement when trading asset futures.  However, it tracks the price of the underlying cryptocurrency say Bitcoin.

A trader can either bet on cryptocurrency price movement to increase (long position) or bet on prices to reduce in future at close (short). Long means you bet for the price to increase at close of the futures contract and the benefit is the difference between the opening and close price. You can also borrow to multiply your speculation and as said, the leverage is high meaning you retain a small equity stake. Notice that you make a loss if the price movement is against your bet or speculation. Since a long means buying the contract now at a lower price and selling the contracts later at a future date, the trader pockets the difference. A loss can be made if it defies the price movement as per speculation.    

Shorting means betting or speculating the price of the asset to drop at a future date and you can also multiply the bet by borrowing crypto – hence gaining the difference in price movement. In this case, the trader will sell a contract at a higher price believing the price of underlying crypto such as Bitcoin will drop and when it does they will buy back the contracts hence getting the difference as profit.

As a reminder, cryptocurrency exchanges allow settling of futures at the closure of the contract, in crypto so it is settled in crypto although some settle in stable coins such as USDT these days. Therefore, ideally the profit should be the difference in price bet at the start and close and the profit remains in your wallet or account when you pay the borrowed amount.    

To understand futures, they are common in commodities market where a farmer for instance would enter into a contract to sell their produce at a specified price at a future date and therefore avoiding the risk from dropping of the commodity prices.  

There are two types of futures; those that trade and settle in USD such as CME and CBOE Bitcoin futures and those that trade in USD but settle in BTC for instance on many crypto exchanges. Apart from traders, futures are used by miners to guarantee the value of the crypto they are mining.

When trading them on a crypto exchange, futures allow you to get high margins in that you can borrow USD value to multiply your profit or leverage. In that case, you would need to deposit some USD as collateral.

Futures can be profitable depending on the market conditions. In addition, they are cheaper than short selling because the trader does not need to settle daily margin funding. They also carry lower margin requirements and the trader can choose between USD and crypto for margin funding.

The problem with futures is although major coins are supported on many exchanges that do offer futures, most crypto tokens are not yet supported.  Also, like with the case of short selling, the risk hedging may be ineffective in some cases and this is caused by deviation in cryptocurrency prices between the exchange you are trading futures and the other exchange you use. There is also the basis risk, defined as the deviation in future prices where airdrop and forks and other events may cause these differences.

Perpetual futures

These kinds of futures are similar to futures above except that they do not have a settlement date on which the trader should close the contract.

Options Trading

Options are utilized by cryptocurrency traders to generate a potential profit even in a falling market. The holder of the crypto has the right and not the obligation to buy or sell an asset at a specified future date and specified price. Remember for the futures, the contract is an obligation and must be done.      

 A put option is bought when the trader believes the price will drop. Basically, the trader buys the put option with a strike price below which they believe the price will drop, and pays premium when buying the option. The “writer,” or seller, of the option takes the premium as the income. If the price drops below the strike price as expected by the trader, they will make a profit, which is the difference between the price at which the option is executed and the market price of the crypto minus the amount paid for the premium.   

If the options expires and the strike price has not been met as expected by the trader, the trader will lose the premium. Options are an inexpensive way of shorting cryptocurrencies.

Options contracts are either call and put options. Call options is when a buyer purchases an underlying asset at a given strike price and put selling the asset at a given strike price. The buyer of the call will profit when the underlying asset price is greater than strike price while the buyer of a put profits when the price goes down below the strike price. 

Options are more suited to experienced traders. Speculators use options to limit downside risks and get exposure for a fraction of the cost. When buying, the premium to be paid is determined by factors such as moneyness (the assets current price vs. strike price), time to expiry, and implied volatility. Options can be used by long term holders and miners to earn income by selling them.

For a more detailed explanation on options, please visit this link.

Diversifying your crypto portfolio

The old saying don’t put all your eggs in one basket is true in a volatile market like crypto when the price is falling differently between different cryptocurrency assets. And that’s what happens. Volatility is never the equal for all assets although the overall market tends to move together to one direction. How do you formulate your diversification strategy? Starting with the more reputable coins because they are lesser volatile than small cap coins.

Other methods

Prediction markets

Prediction markets such as Ethereum-based Augur, on which people can predict outcome of any event and are rewarded with crypto when they win, can be used to express short views on cryptocurrency in that one can predict crypto prices and hedge.

Crypto ETNs

Cryptocurrency exchange-traded notes (ETN) such as Bitcoin Tracker One, Litecoin Tracker One or the Ether Tracker One by XBT Provider, on the Stockholm Stock Exchange are regulated financial products and sold on brokerage exchanges that support them. Some exchanges allow short selling of cryptocurrencies.

Binary Options

Binary are financial derivatives that allow one to predict the price movement of the underlying asset – usually for a very short period like ten minutes – and then the payoff is either a fixed monetary amount or zero.

 

David Kariuki

David Kariuki likes to regard himself as a freelance tech journalist who has written and writes widely about a variety of tech issues that affect our society daily, including cryptocurrencies (see cryptomorrow.com and coinpedia.org); climate change (cleanleap.com), OpenSim and virtual reality (see hypergridbusiness.com). He is currently pursuing a MSc in Environmental Management at Open University. He does write here not to offer any investment advise but with the intention of informing audience, and articles in here are of his own opinion. Anyone willing to use any opinion here as advise to invest in crypto should obviously take own responsibility and accountability of their losses (or benefits) thereof. You can reach me at [email protected] or [email protected]

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