Cryptocurrency investors have been finding ways to deal with the ongoing Crypto Winter. However, professional investors are the ones who have been around in the market and have learned the skill to make profits regardless of the market direction.
For a new investor, it can seem like an unlikely idea. To ensure maximum returns potential for cryptocurrency investors this article is going to explain in detail a trading technique called Hedging.
What is Hedging?
Hedging is not so much a trading activity as much as it is an ideal parameter for investors. Hedging involves generating multiple trading positions to the effect that it reduces the risks of losses.
Furthermore, hedging also involves adopting trading techniques that mitigate the impact of price volatility and uncertainty from the markets. In simple words when one trading position incurs losses the other one is going to incur gains to offset it.
The main objective of hedging is to take two opposing trading positions. In this manner, when the market moves in one direction the trader is sure to make a profit despite the warranted losses on the reciprocal trading bet.
Hedging is also about performing technical analysis on two trading products that are going to move in a different direction. In case the first trading product falls based on the fundamentals, the other product should be the one that will increase due to the same factors.
How does Hedging Work?
Hedging is one of the most common ways of securing profits and becoming independent from market forces. However, Hedging does not mean that investors can pick and choose opposing trading products based on their gut feelings. Investors who wish to find these reciprocal trading assets must rely on extensive technical analysis and ensure that they can make decisions based on statistical analysis.
Hedging is a trading technique that most short-term and medium-term investors employ more commonly. It happens because phenomena like volatility and rapid market factors change in shorter terms. Whereas, the Long term positions are less sensitive to short-term market variables. Here are the basic steps to perform hedging for any trading product:
- Conduct market research, learn to read technical and fundamental analysis, and get familiar with trading products such as cryptocurrency.
- Learn about the various types of Hedging techniques and how to implement them.
- Make a list of all cryptocurrency platforms that offer hedging services, list their features, and pick the best platform.
- One important tool for hedging is derivatives therefore, learning about derivatives such as forward contracts, futures, options, and other options is a great advantage for hedging investors.
- Hedging is basically about creating opposite positions. Therefore, if one position is long the other one should be short to perform hedging.
- Liquidity can make a huge difference in the success of hedging. Investors can estimate factors like market integrity, speed of transaction, and fluidity from liquidity and avoid price slippages.
- Hedge investors can never ignore the benefits of diversification. It means that an investor can create multiple positions in Bitcoin, Chainlink, Ethereum, and other crypto tokens to generate a well-balanced and healthy portfolio.
What is a Hedging Strategy?
A Hedging strategy is a type of investing style and technique that allows investors to use hedging in different manners. By selecting a suitable hedging strategy, the investors can work in the organization and they will not be swayed by market speculation.
Furthermore, using one particular hedging strategy is like using a quantified system that does not let the investors dwindle between different modes of trading, which can harm their hedging positions. Here are some of the most popular types of Hedging Strategies:
Short selling is a process where the investors can generate profits dealing in negative balances. Rather than purchasing for lower prices and selling for the high one, investors sell an asset for higher prices and purchase it again at lower costs. It is natural that by using shorting techniques investors can hedge with ease. There are usually two types of shorting options given:
Margin Trading: This is shorting option where the investors use borrowed or leveraged positions. It is riskier and the investors are under obligation to maintain a predetermined amount of collateral.
Traditional Shorting: The investors can commence by creating a negative credit of sold cryptocurrencies on DEX or CEX platforms and wait for the prices to fall lower to purchase them and make profits from the differences.
Futures are the derivatives that track the performance of an underlying asset. These derivatives are like the future purchase or sell contracts that predict an increase or decrease in the prices of its underlying asset.
However, futures come with an expiration date and they can sell before it. When dealing with futures, the investors are under an obligation to sell or purchase the contract. Futures are a type of derivative that is also a major instrument for hedging.
Futures contracts allow investor to keep their trading positions open to maximize their profits. Here are some major benefits of hedging with futures:
Investors can reduce the probability of losses created by the unprecedented changes in the prices depending on long or short positions.
- Investors can freely speculate about the direction of the market by using futures.
- Futures can balance out price changes and make the exposure smoother.
Perpetual Swaps are also derivatives that allow investors to track the performance of an underlying asset. However, the main difference here is that Swaps do not come with an expiration date. They do have a time limit on them but the investors can extend the limit after paying the funding rate which is a set fee or a rebate to keep the position open.
However, investors should pay attention to the factors like funding rates, potential returns, and leverage policy of the platform where they are dealing with perpetual swaps. Here are some major advantages of hedging with perpetual swaps:
- The liquidity of perpetual swaps is considerable since they are renewable and it allows more investors to keep their positions open.
- The greater the leverage the more these investors have a chance to make more profits using smaller capital.
- Perpetual swaps are best for short and intermediate positions.
One disadvantage of perpetual swaps is that it has unpredictable hedging costs due to the ever-changing funding rates.
Options are also derivatives and they contain expiration dates as well. However, unlike futures, the investors are not under obligation to make sales or purchases when the expiration date has passed.
Therefore, Options are often seen as an ideal apparatus for performing hedging. The options that grant investors a right to sell are called puts while the purchasing rights options are known as calls. Here are the main types of options hedging that every investor must know:
The investors can issue call options against the asset under their possession. In this manner, the investor would be able to hedge against lower prices. The ideal time to use this derivative trick is when the market is about to decline or move sideways.
Furthermore, the investors should keep in mind the premium amount to ensure that they are in control of their final profits. Using the Covered call, the investors can get two folds of profits one from the premium income and the other from the capital gains provided that the trigger price is not breached until the expiration date.
A protective put is very much like a covered call but it works for long positions. In this method, the investor can issue a put option for the assets under their positions. This put works best when there is a strong possibility of the market going up.
It is a great way for generating profits that warrants a return with the promise of maximum losses limited to the extent of the premium investors has paid.
Married Put is another great way to hedge using derivatives. The married put is much like a protective put but it is not against the position that you are holding. Therefore, investors purchase the option at the same instance as they purchase the underlying asset.
For this option to work, the investors must try to seek a strike price as close to the purchasing price. However, investors can also go with the OTM strike. In this option, the consumers make profits, when the price of the underlying assets grew larger than the premium.
The collar is a type of Option hedging that grants all the benefits of a protective put but for a fractional cost in comparison. Using Collar options, the consumers can combine a covered call and the put option technique in one derivative contract. The put option is warranted to save the investor from the downside movement and the premium will guard their positions against big losses.
The investors make profits when the prices of the underlying assets are near or equal to the strike price when the expiration date arrives. Collar options are ideal for the markets when they are moving sideways but wish to protect their positions against unwarranted big losses.
Investors are also known to hedge their positions by creating long and short positions with a pair of positively correlated assets. Therefore, when the price for one asset class goes down the consumer may suffer from losses on its long or short position.
However, at the same time, the investors will also make profits on the reciprocal position of the other trading product belonging to the same trading pair.
Safe Haven Assets
Some assets are considered safe and secure on account of their universal adoption and global liquidity. Therefore, the investors also perform hedging by investing in commodities like gold and currencies such as USD and Euros, etc.
It is one of the most obvious yet effective ways of hedge trading. Investors can distribute their trading capital among a diverse group of assets to ensure they can keep earning profits when one asset goes down and others keep appreciating.
Furthermore, when the market conditions change the portfolio will remain intact because the other profits will now generate profits that were in losses before and vice versa.
Forward Contracts are much like futures contracts in that they are tradeoff certificates based on a limited time frame. However, Forward contracts are derivatives that are not standardized and belong to the OTC and decentralized platforms.
They carry a larger risk of not getting honored by the users. However, in the DeFi ecosystem, there are several platforms where investors can find forward contracts.
Advantages of Hedging
Here are the advantages of Hedging that the investors will be able to benefit from provided that they can master the art of hedging:
Without hedging it can be very difficult for investors to manage their risks. Even when crypto market analysts can read the market vitals they are unable to make predictions about market movements with 100% accuracy.
Therefore, using techniques like hedging is a great way for consumers to get benefits from the marketplace and make sure that they can reduce their risk percentage by several folds.
Market uncertainty is one of the greatest obstacles for investors in making profits. Against all preparations and analysis, investors are always facing a considerable chance of facing an untamed market.
Market uncertainty is more real for cryptocurrency investors because it is largely an international market and the variables become too big to measure at a time. Therefore, adopting hedging is a great idea for investors to ensure their safety.
Protection from Fundamentals
According to the Wyckoff Accumulation Theory, the forces of supply and demand are always affected by macroeconomic factors. Hence, it is concluded that fundamental factors such as inflation, forex rates, premiums, service charges, and interest rates can make or break the portfolio of investors.
Under these circumstances, hedging is one of the best trading options to ensure the protection of funds and mitigate risks.
Hedging essentially preaches and teaches investors to create multiple reciprocal trading positions. Therefore, hedging takes advantage of the smart principle of not portfolio diversification.
The idea that investors must never put all their eggs in one basket has become so prevalent and accepted that it is impossible to ignore this basic tenet that is an inherent part of hedging.
Liquidity is the backbone of successful trading and good assets. Therefore, by using hedging the investors are unwittingly contributing to increasing the liquidity of the said product. Therefore, when investors are using hedging techniques they are contributing to the greater good which also increments their chances of making a profit.
Limitation of Hedging
Here are some of the downsides associated with hedging that every investor should keep in mind:
Smaller Profit Margins
It might seem that hedging is a surefire way to make profits. However, the fact of the matter is that a very limited number of investors have managed to generate profits using this method. The best result of hedging is that it can minimize the risk of losses associated with this investment product at best.
Therefore, most investors who are unable to understand it properly end up in break-even with small losses or small profits that do not grow their profits by a considerable margin.
Lack of Trading Strategy
Most investor learns about hedging and considers it a magic solution that is going to make them rich quickly. However, going into any trading position without a proper strategy is destructive. Therefore, rather than making the rookie mistake of jumping into hedging without any technical analysis and solid basis, it is best to do some research and make logical decisions.
Difficult to Execute
Hedging is a great way to decrease risks and increase profits. Therefore, it is also a skill that is difficult to master. The main reason is that most hedging techniques involve options like working with derivatives, correlated assets, trading pairs, and even leveraged positions.
All of these trading options require years of trading experience and knowledge in financial training to implement with success. Therefore, the downside of hedging is that it demands dexterity and experience.
The dynamics of the investment market and economic conditions are always in a state of constant change. Therefore, the best way for an investor to survive in the market is to mitigate risk by using trading techniques like hedging. At the same time, investors should keep in mind that hedging is not a magic spell to ensure 100% profits all the time.
On the contrary, it is a technique that takes time and effort but the payoff is always worth the hassle.