Definition of Hedging in Trading: Hedging is a risk management strategy used by traders to offset losses on an investment.
The three most common methods of hedging are portfolio diversification, short asset selling, and the use of derivatives such as futures.
Cryptocurrency hedging is not completely safe: there is no guarantee that the price of a particular asset will go up or down, even if you see relevant signals on the price chart.
What is hedging?
Hedging is a risk management strategy used by traders to offset investment losses. Hedging means taking a position in an asset that is opposite to your current open position. Traders treat hedging as a form of insurance that protects them from negative impacts on their investments. It should be noted that hedging does not prevent side effects from occurring. Hedging is a strategy to reduce financial losses from investments.
Why hedge cryptocurrencies?
The cryptocurrency market is highly volatile. Sharp and sudden price movements that rise as quickly as prices fall are prevalent. For example, in January 2021, the price of Dogecoin (DOGE) rose significantly from about $0.008 to about $0.08 within 24 hours. However, the price plummeted about 72% to $0.022 the next day. Over the next few months, the price of doji has risen more and more, but not all cryptocurrencies have experienced the same recovery.
Interestingly, many cryptocurrency traders view market volatility as an opportunity to make money, but at the same time are exposed to the risk of huge losses.
Separately, cryptocurrency was created with decentralization in mind. Virtual currency lacks the regulations that most financial institutions have in its nature. As such, the cryptocurrency market is not subject to the requirements, restrictions and guidelines that traditional financial institutions follow.
Unfortunately, the absence of these regulations also reduces the chances of cryptocurrency traders being protected, increasing the likelihood of significant losses. As a result, cryptocurrency traders must rely on experience, personal judgment and the market when trading cryptocurrencies.
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Minimizing Trading Risk with Hedging
In particular, traders can use risk management strategies such as hedging to minimize the above cryptocurrency trading risks. For example, although a trader currently holds a profitable position in Bitcoin (BTC), the trader predicts and believes that the price of Bitcoin will fall either based on their intuition or the information they are getting from the market.
Thus, the investor will have a plan to hedge the asset. To hedge, the trader adds a second position opposite the current profitable position to protect the unrealized profit. If the market changes direction, the initial profitability can be negative. On the other hand, taking a secondary position while hedging produces a profit that covers part of the loss incurred in the initial position. This is usually done through short selling or futures trading.
How to hedge cryptocurrency
There are various cryptocurrency hedging strategies that traders can use to mitigate risk. The three most common methods are portfolio diversification, short selling, and the use of derivatives such as futures. Thus, hedging is not an isolated investment strategy in itself, but rather the use of a variety of different risk management strategies in the context of a specific market downturn.
Portfolio diversification
Having a diversified portfolio can be the simplest way for traders to minimize their losses in the cryptocurrency market. Diversification means purchasing various crypto assets instead of investing all your funds in one cryptocurrency. In other words, “You don’t put all your eggs in one basket.”
In a diversified portfolio, each cryptocurrency acts as a hedge against other cryptocurrencies. As a result, when the price of one token falls, the overall loss is less than if a trader invested their entire funds in one cryptocurrency.
A diversification strategy involves investing your money in investments that do not move in a generally and preferably uniform direction. The most optimal scenario would be for traders to invest in a variety of unrelated or unrelated assets. However, the cryptocurrency market is different from the traditional stock market, which has a variety of asset classes and includes different industries. Cryptocurrency assets are very similar and tend to move in the same market direction. Therefore, it can be difficult to achieve a fully diversified cryptocurrency-only portfolio.
Nevertheless, cryptocurrency traders should devise an appropriate portfolio diversification strategy. Traders should do their own research on which cryptocurrencies to include in their portfolio. In general, a portfolio should contain a good mix of different coins and reputable coins such as Bitcoin ( BTC ) and Ethereum ( ETH ) to offset the high risks associated with altcoins.
It’s okay if investors want to look outside to diversify their cryptocurrencies. Bitcoin has been viewed as an uncorrelated asset with many other assets, with a low correlation with stocks (S&P 500 Index) and a very low correlation with tech stocks. This is represented by the Nasdaq-100 Index, a large capitalization index. So, if you want to diversify away from Bitcoin, these options will be viable options.
The data shows that the correlation between Bitcoin and the Nasdaq-100 measured at the end of May was around 0.20 on the rolling 20-day average and the correlation with the S&P 500 was 0.29 on June 2nd. On the other hand, Michael Saylor’s MicroStrategy has a much higher correlation of 0.73. This means that if you are looking to pursue a variety of hedging strategies against falling cryptocurrency prices, it is safer to invest in less correlated assets such as Nasdaq or S&P 500 stocks, but you should be especially careful to avoid assets that move with the cryptocurrency industry.
Short selling assets
Short assets are a more advanced way for traders to hedge cryptocurrencies. Short selling refers to a trading method in which an asset is sold at a lower price when it is determined that the price of an asset will fall soon. By doing so, traders benefit from the difference.
Short selling starts with the trader analyzing the price chart of a particular cryptocurrency. For example, use divergence analysis to check for signs of potential trend reversals. When a trader sees a signal that the trend is reversing downward, they can borrow a specified amount of cryptocurrency from an exchange or broker and sell the borrowed tokens on the market. When the price of a cryptocurrency falls, the same amount of tokens can be bought back at a lower price and returned to an exchange or broker. However, if the price rises, traders have to buy back the same amount of tokens at a higher price and lose money.
For example, let’s say a trader shorts BTC and borrows $1,000 BTC for $60,000. If the price of BTC drops to $50,000, the trader only needs to spend $833 to repurchase the same amount of BTC, resulting in a profit of $167. However, if the price of BTC rises to $70,000, the trader will have to pay $1,167 to buy the same amount of BTC again, resulting in a loss of $167. Traders can set a Stop Loss limit near the initial price of $60,000 to avoid huge losses.
It is important to note that hedging through short shorts entails transaction costs and margin interest, which can reduce profits. Therefore, traders must do some pre-calculation before borrowing and selling certain cryptocurrencies.
Make use of gifts
Traders can also hedge cryptocurrencies using derivatives. Derivatives are contracts that derive value from a major underlying asset. The most common derivatives traders use to hedge cryptocurrencies are futures. A futures is a type of financial contract between two or more parties who agree to trade a specific crypto asset at a predetermined price on a specific date in the future. Cryptocurrency futures help traders mitigate the risk of a price decline by taking a short futures position and profit when the price rises by taking a long futures position.
For example, suppose a trader has 1 BTC worth $60,000 and wants to invest at this price. Each futures contract is worth $1 BTC at this price, so a trader needs 60,000 contracts to open a position. The trader prepares to short the contract in anticipation of the price. When the price falls on a predetermined date, the trader buys back the futures at a lower price to make up the difference. However, if the price rises, the trader will buy the futures at a higher price and lose money. On the other hand, if a trader takes a long position and holds the contract, he gains when the price goes up and loses when the price goes down.
Profits can increase when traders utilize a high level of leverage in futures trading. However, losses from adverse conditions will also be greater. Therefore, traders should be wary of the risks of using leverage when trading futures. The use of derivatives and short selling in the context of hedging (hedging) is called short hedging. Short hedging involves the use of derivative contracts to hedge the potential loss of an owned investment by selling an asset short or selling it at a specified price.
How to properly hedge cryptocurrencies?
For novice traders who are concerned about trading risks and don’t have time to study the charts, you should opt for the safer option and close or reduce the size of your position. For people, hedging can be a useful strategy to hold on to stocks and mitigate losses during market downturns.
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Cryptocurrency hedging 4 step process
- Traders should do some preliminary research and learn how to use, read and analyze price charts before applying a hedging strategy.
- Traders need to learn how to trade on cryptocurrency exchanges.
- After traders understand how to trade cryptocurrencies, they can practice hedging strategies using simulation trading.
- As traders get used to it, they can start hedging real cryptocurrencies in small amounts and move slowly to larger positions later.
The golden rule is for traders to take the opposite stance when it comes to hedging cryptocurrencies, i.e. traders should take a short position if they think the price of an asset will fall and a long position if the price is expected to rise. However, cryptocurrency hedging is not entirely without risk. Even if relevant signals appear on the price chart, there is no guarantee that the price of a particular asset will fall or rise. As a result, traders must weigh the pros and cons when deciding which cryptocurrency to hedge and which hedging strategy to use.
Summary
Hedging is a popular strategy used by traders to mitigate risk in traditional stock and cryptocurrency markets. This is a useful strategy for maintaining your cryptocurrency holdings and protecting your profits in a highly volatile investment environment. The three most common cryptocurrency hedging strategies are portfolio diversification, short selling and derivatives trading. When applying a hedging strategy, traders should be aware of the risk of using leverage, which can reduce trading fees and profits.
Traders should keep in mind that hedging is a risk management strategy. There is no guarantee that hedging will mitigate risk. Because it can sometimes backfire and limit the amount of profit that can be realized. Therefore, traders are encouraged to practice beforehand by understanding and utilizing the available hedging methods before using them for trading.
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Comment by Hans
April 24, 2024
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