From a multiyear profitability perspective, Bitcoin (BTC) easily ranks as one of the 21st century’s most successful assets. But sometimes, altcoins like Ethereum (ETH) outperform BTC due to changes in the crypto ecosystem. Although coins like BTC and ETH have seen exponential growth since their launch, the ride to recent highs has been anything but smooth.
The market prices for crypto coins and tokens drop as swiftly and unexpectedly as they catapult to the moon, which presents traders with substantial risks and opportunities. While nothing is certain with crypto, one strategy traders use to manage market volatility is “hedging.” A well-hedged portfolio decreases a bad trade’s impact, sometimes strengthening a trader’s long-term purchasing power.
So how does hedging work in crypto, why is it such a powerful strategy for traders, and what are the most popular ways to trade crypto with hedging? Let’s find out.
What is Hedging in Crypto?
Hedging cryptocurrencies is a strategy where traders simultaneously open two opposing positions in a digital asset. Typically, the purpose of hedging is to provide traders with a form of insurance when the prices move in an unfavorable direction.
Hedging also curbs crypto volatility by reducing the downside risk of virtual currencies. For instance, if you have a significant position in Litecoin (LTC) and want to hedge your LTC holdings, you can buy a contract that only profits if Litecoin’s price drops. Here, even if the LTC’s market price falls, you don’t lose as much money because the value of your Litecoin contract increases. The extra money you earn from this Litecoin hedge also reduces the average purchase price (aka cost basis) for the LTC in your long-term holdings. Simply put, if you hedge your position, Litecoin’s price doesn’t have to rise as much from a dip for you to break even.
How to Hedge Crypto: 5 Common Hedging Strategies
Many popular crypto hedging strategies use products called derivatives, which are contracts tracking the value of crypto assets. Some traders prefer using derivatives for hedging because they give price exposure to cryptocurrencies without the need to store an underlying asset.
You can also leverage more direct ways to bet against cryptocurrencies (e.g., shorting), but these techniques carry significant risks. For this reason, you should evaluate different hedging practices to figure out what works best for your risk tolerance.
1. Crypto Options
Crypto options contracts give traders the right to buy or sell a set amount of cryptocurrency at a specific price (aka strike price) by an expiration date. Call options profit when a digital asset’s price goes up, while put options benefit from crypto price declines. If a trader already holds Bitcoin and wants to hedge their position, they can buy BTC put options to reduce their downside risk.
Alternatively, traders sometimes sell Bitcoin call options to bet against BTC’s price. In the second scenario, traders collect the fee for the option (aka premium) upfront and get to keep the premium if Bitcoin’s price stays below the call option’s strike by expiration. However, when traders sell call options, they have an obligation to buy BTC if a call option’s holder exercises their right to purchase Bitcoin.
2. Crypto Futures
Like options, crypto futures contracts are derivative products with specific strike prices and expiry dates for digital assets. The difference between options and futures is that the latter closes on the expiration date regardless of whether the contract’s holder wants to settle their position. In other words, there’s no option to exercise or defer a futures contract—these derivatives always settle at the agreed-upon price on the final date.
3. Crypto Perpetuals
Crypto perpetuals are a more flexible form of futures contracts because they don’t have an expiration date. Rather than settling cash or crypto transfers on a specific day, perpetuals use a fee-and-rebate system to naturally balance the market price of each contract. For instance, when Bitcoin’s price falls, perpetual traders who bet against Bitcoin (aka shorts) pay a fee to people predicting BTC will rise (or longs), and vice versa. The fee-and-rebate model incentivizes traders to take the opposite side of a trade and naturally adjusts market demand to stabilize the price for each contract.
4. Short Hedging
Shorting means borrowing funds from an exchange to sell a cryptocurrency upfront with the expectation of buying the coin or token at a lower price. Typically, crypto exchanges offering short-selling services charge a fee until traders pay off their complete debt. Unlike options or futures, there are no strike prices or expirations when short selling, which puts traders at risk of theoretically unlimited losses if a cryptocurrency skyrockets. While short selling has potentially higher upside than derivatives, the combination of borrowed funds and unlimited loss potential makes it one of the riskiest hedging strategies.
5. Inverse Crypto ETFs
A crypto exchange-traded fund (ETF) is a regulated product class that gives traders access to a professionally managed pool of assets such as cryptocurrencies, crypto derivatives, or shares in crypto-related businesses. One way crypto traders use ETFs to hedge their crypto portfolios is to buy shares in an inverse crypto ETF such as ProShares’ Short Bitcoin Strategy ETF (BITI). Typically, inverse crypto ETFs contain derivatives like short futures contracts or put options to profit from price declines in digital assets. Unlike cryptocurrencies and crypto derivatives, ETFs trade on TradFi markets like the Nasdaq, so traders need a brokerage account to buy ETF shares.
Pros and Cons of Hedging Cryptocurrencies
Hedging is a powerful tool to preserve purchasing power, but it’s not without its drawbacks. There are a few hedging trade-offs to consider before opening opposing positions.
Benefits of Hedging Crypto
Protects against volatile price movements: Traders often use hedging to minimize the potential price loss in a long-term cryptocurrency position. Even during a bear market, crypto traders with hedged positions may be able to reduce their total losses and recover lost gains more quickly.
Offers a wide array of financial products: Traders choose from dozens of financial vehicles, price levels, and time horizons to create their personalized hedging strategy. From options and futures contracts to perpetuals and short-selling, there are plenty of ways for crypto traders to build their preferred position.
Helps set a precise risk tolerance: When traders enter a hedging position, they take some uncertainty off the table. Even if a hedging position doesn’t turn out as expected, a hedge contract can help traders not lose as much if there’s a sudden market correction, which makes it easier to calculate risk and potential loss.
Doesn’t require selling long-term crypto holdings: Hedging with derivative products like options, futures, or perpetuals lets traders profit from downward price action while holding the target digital currency in their wallets. This way, crypto traders get to keep their favorite digital assets while mitigating the damage of short-term downtrends.
Drawbacks of Hedging Crypto
Sometimes reduces profit potential: Similar to buying insurance, hedging only pays off when something goes wrong. Traders with a hedge position save money if a cryptocurrency’s price drops, but they gain less if a digital asset keeps rising in value.
Not ideal for passive traders: Hedging a crypto portfolio isn’t as hands-off as other crypto trading strategies like the HODL method. Traders must feel comfortable monitoring the crypto market and adjusting their positions frequently.
Higher learning curve: People unfamiliar with crypto derivatives like options, perpetuals, and futures need to spend extra time researching advanced trading strategies. It may take a few days or weeks to fully grasp the differences between hedging techniques and practice how to place trades on crypto exchanges.
Eligible Traders can Hedge Their Crypto Positions on dYdX
As the leading decentralized exchange for crypto perpetual swaps, dYdX offers eligible traders a simple way to hedge their positions with Bitcoin and altcoin derivatives. After linking a supported crypto wallet to dYdX’s exchange, eligible traders can enjoy deep liquidity for dozens of crypto perps, plus advanced features like slippage tolerance controls, leverage, and multiple order types. Learn more about dYdX’s latest upgrades and features on our official blog.
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