The cryptocurrency domain is risky. Some even say that it is riskier than traditional equities and bonds due to the macro environment present in the world today. People understand that these digital assets that range from bitcoin to ethereum and other legitimate assets can be quite volatile in nature. At the same time, most people keep it simple and keep a long only approach to their portfolio.
A long only approach essentially means that investors will buy a digital asset and then hold it. The investor will not have any consideration in regard to risk besides buying the digital asset at a price that they are comfortable with in the short or long run. While this may be a sound approach for many investors it does not account for the nuances of risk present within the equation.
What should investors do if they feel that they should do more to hedge or counteract risk that may occur in the digital token landscape? First, they should realize that there are many conventional ways to hedge risk within the portfolio. Second, take action by implementing the tactic that works best on a personal level.
Let’s find out more about the definition of hedging and different ways to hedge risk in the cryptocurrency space.
What is Hedging?
The first detail to know is that hedging is not something to do with you bushes or general fauna and flora. It has to do more with risk tolerance and control. Hedging is a critical component of a long term investment portfolio. Investors who seek portfolio optimization would want to protect their portfolios by including tactics that let them minimize risk exposure.
The central idea is to minimize loss potential in an investment by making an investment in antithetical investment. Yet another point to consider here is that protection strategy can cap upside gains as an investor must allocate less capital to initial assets.
For instance, Howard Marks thinks that bitcoin will go upto a $100,000 in one year. At the same time, he wants to have a price floor or have a way to counter this trade in the event of bitcoin declining significantly. What is he to do? If he wanted to invest a total of $50,000 in bitcoin but wanted to protect himself he would place a significant portion into bitcoin and then use a modest sum to conduct his protection scheme.
Howard Marks might turn to derivatives such to conduct the right hedge. Marks might think that the proper insurance for bitcoin might be to sell it short or to buy a futures contract. The point is that Howard Marks might not be completely insured or protected against what might happen to bitcoin but is safer than others in the market.
Now, seeking protection from adverse events is something that we practice in all aspects of our lives.
Remember that you get protection in your regular life. This might be by buying car insurance so you have protection if you get into a car accident. You might purchase home insurance to protect yourself financially against potential physical calamities.
Risk mitigation is present almost everywhere, and we see it every day. For example, if you buy homeowner’s insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters. Everyone from individuals to businesses wants to reduce risk and they do so by buying some form of insurance. Similarly, the financial sector compels people to tactically use financial vehicles to hedge against inverse movements.
One simple set up is to offset positions in specific assets by paying for opposite correlations. In the traditional financial market, if you are interested in Google but want to protect yourself, you may acquire an option known as a put. If Google falls, the put insurance protects you if it falls to a certain level.
Decreasing your risk exposure means incurring costs that will eat into your bottom line but that is the price your pay for protection. It is true that you may be able to profit from your downside protections as well but this is not always the case.
Let’s talk more about selling vs hedging.
Divesting Assets vs Hedging
Most people wonder why people are interested in conducting hedging strategies and making things even more complicated when they can just sell when they want to and whenever they want. The simple answer is that simple selling can incur different expenses that range from taxes to lost gains. It might not allow you to capture the upside of an inverse market.
Let’s talk about the first hedging strategy of short selling.
Thankfully cryptocurrency offers ways to have insurance against your investments. One simple way is to sell a digital token short. For instance, if you are acquiring bitcoin then you might opt for selling it short on the flip side. But you must account for the short selling costs such as the fee to trade, the loan or margin cost. Depending on how long or how heavy you wish to hedge with this strategy, you may incur significant costs.
But crypto short selling allows you to minimize risk in more ways than one. For instance, with short sales you are able to place only a little capital and have that at cyber risks. Then you would short sell instead of regularly selling your asset because you don’t want to sell it, then buy it again to incur transaction costs on both events. Further, the spread risk is also large and you might sell it at a lower rate and then buy it at a higher rate, the opposite of what you want to do.
Implement this Short Sell Strategy
Create an account at an entity such as Binance or another company that has the ability to short sell. You might need some fiat or stablecoin to continue to hold your hedging position in tact with the firm. Here is how you would conduct this play.
First, place your bitcoin or your euro or usd into the account so you can fund your margin account and short sell. The requirements will vary based on the entity your use. You can short sell at unit to unit ratio, meaning if you buy 15 bitcoin, you can short the same amount as well.
Watch your short transaction and see how it is doing as you would your long position. The reason why you want to monitor this in a cautious way is because you don’t want to run low on funds in your margin account. Finalize the short transaction when you think it is the right moment to do so.
A large problem in cryptocurrency sector is the variation between prices on different hubs of activity. For instance, if you are on Kraken you might see the price of the asset as $12,000 while if you are on Poloniex, it might be $10,000 at the same instant.
You already see the price discrepancy but what if you set a short position in one and don’t see it go down as you need it to, while it does go down in the other hub? That aspect is what causes one to tread with caution in this approach.
Watch out for the potential in transactor default risk, asset tied additions, and creation of new currencies.
Remember that futures are simply one way of setting a price and date to buy at or sell at in the future. People do this to protect themselves in the present if they see some fluctuation in the asset. It is a great way to protect yourself by trading a futures contract in a fiat or in usd/bitcoin. These contracts also require an initial input or a margin position and you must continue to fund it if it falls.
Thankfully, futures are cost effective insurance because you do not have to place a large portion of assets upfront, you can increase your leverage and have the funds to continue to fund it. Futures can be a simple way to profit from your protection. What is great about this aspect is that you are able to know how much it will cost when you enter into this position. What will this cost you? The cost to enter into the contract and the discount/premium of the contract.
These contracts offer many different benefits and provide you with more flexibility overall, as such, many people can get involved in these contracts.
Implementing the Futures Contract
First, you will need to have an account with a platform that offers futures contracts. Select the right contract, do you want to settle in the cryptocurrency or the fiat currency? Always account for costs involved in the process. Look at your assets and what you want to hedge for and move accordingly.
Watch your progress on the account and fund it as you need. Account for time as well. Watch for the movements in the underlying component. Finalize when you feel that it is the right time to do it.
It is best to practice with each of these approaches before putting money on the line, choose these contracts, and act as if you have money in it, watch it, and then refine if you got it wrong. Look at how much money you would have lost or would need to put up to continue the contract.
There are risks involved with these protections so it is best to understand it all before you go fully into it.
These are contracts that have come to light with players such as Bitmex. One must continue to monitor and re-allocate funds to these positions periodically and then they may not have a set period when it will close. Remember that with futures we have price and a specific close date but with perpetuals we do not.
Again, this is not a simple concept and one must make sure to utilize it properly and securely. It will take practice and require patience, caution and great due diligence to implement in a proper manner. The complexity comes from the rolling basis or the continuous calculations for funding it.
People use this because they find that it is more in line with the actual asset than others like futures. The variance is the funding mechanism as it adjusts around three times per day.
You can implement this in the same way that you do futures except you must make sure that the facilitator hosts perpetuals. Risks are similar to what is found with futures and are present with this component but it can be very helpful for those who are knowledgeable.
Options in this digital asset realm are not present everywhere. They are only present at specific facilitators, in fact, only two entities offer it at the current moment. While they are new in the digital asset industry they are not so in the age old financial industry.
Options are not simple either and require calculation abilities and a deep understanding of asymmetric bets. The end results are called payoffs and you can engineer them in several ways. Implementing this is not always cost effective. In fact, most of the time, these are expensive for a variety of reasons due to volatility and other aspects tied to the cryptocurrency sector.
One does not have to account for margins in this method because it is not about leverage in the traditional sense. People prefer this because they are able to have protection but can also benefit from significant upside depending on the market movement.
You will need an account at the entities that have options offerings for the crypto market.
First, place a put option, in other words you say that it will fall down to this price and I have the option to buy it at this price. You want to make sure to cover the duration of your long trade and more, so if you are holding for one month, you want an option that covers that or is of longer duration. The idea here is to input enough funds to protect your long investment. Place the right portion of funds into the account, fund it, and keep it until liquidation.
Options are not simple but can be a beautiful way to minimize your risk and capture upside.
Everyone in the cryptocurrency industry has strong motivations to hedge out their bets for many different reasons.
Let’s take a miner for instance, this individual or group of individuals must make sure to protect themselves against a bitcoin price crash. They input hard work by setting up the rigs and spending money on electricity. Bitcoin mining is more than about supporting the network, it is about having a profitable operation.
These individuals must predict cash flows and take the right actions to stay solvent over the long term. They will hedge so that they survive even when the bitcoin price crashes.
Cryptocurrency fund managers who want to manage other people’s money must make sure to take the right actions regularly. They will want to hedge to minimize risk of loss of capital. These funds might pursue a variety of exotic strategies to make sure they meet their target returns.
There are those who invest $10,000 in the digital asset market, then others who invest at least $1,00,000 into this alternative market. Those in the latter camp are known as whales as they can get into an asset and move it if they wish to do so.
These large investors have much more invested and will take the necessary steps to protect their investment. They do not want to induce fear or manipulate a bull rally that is weak in nature that is why they will use derivatives and other hedges to keep their portfolio in balance. Hedging can be complex but it is well worth it if you implement it correctly.