What Does Hedging Mean in Crypto? How to Hedge?

As a fluctuating industry with volatility inherent in it, the cryptocurrency market demands various precautions to secure our funds. One of them is hedging, in which you take a counterposition to your existing assets to protect yourself from losses.

This article will act as a detailed guide to hedging, explaining what it is, how it works, and providing a beginner-friendly guide to hedge your crypto. It will also delve into the risks associated with hedging.

What is Hedging?

Hedging is basically a risk management strategy similar to an insurance policy, where an opposite trading position of an existing trade is opened to reduce losses. For example, if you bought 0.01 BTC in spot to HODL, and the price is moving sideways instead of exhibiting an uptrend, you open a 0.01 BTC “short” position in futures to decrease the risk of loss.

Along with the above example, there are multiple hedging strategies you can use to save your funds, including basic safety processes like converting your assets to stablecoins and diversifying the portfolio. As advanced strategies come with various risks, hedging is not recommended for beginners.

How to Hedge Crypto? Beginners Guide

Hedging in crypto is the same as hedging in the traditional trade markets. Let’s assume that you have an existing position of 1 ETH in the spot account of a centralized exchange. Contrary to your expectations, it is moving sideways, and you fear a sudden downtrend, which might drain your portfolio. To contradict it, you employ hedging, in which you should take a counterposition to the ETH.

• Short 1 ETH in Futures Contracts or create a put option in Options Contracts.
• You can also use Perpetual Swap Contracts or Contracts for Difference (CFDs).
• Don’t forget to create a stop loss.
• If you reach a position where the losses are covered, you can exit from both positions, or continue if you like taking risks.
• In case of shorting in the primary position, you take the opposite position of buying the asset.

Types of Crypto Hedging Strategies

There are many ways in crypto markets where an investor who fears loss can implement hedging. As said above, the strategies include buying or selling in Futures Contracts, Options Contracts, Contracts for Difference (CFDs), Perpetual swap contracts, and many more methods.

• Futures Contracts: This can be used as a hedging aid because it allows an investor to buy or sell an asset at a predetermined price at a specific future date.
• Options Contracts: This allows a put option (to sell) if you worry about a price drop, and a call option (to buy) if you worry about the asset surging.
• Contracts for Difference (CFDs): CFDs are derivative products that allow you to hedge against price changes. You can short-sell CFD to counteract the bear phase and buy it to go against an uptrend.
• Perpetual Swap Contracts: These contracts track the price of an underlying crypto asset and allow opening larger positions with heavy leverage. The buy and sell work the same way as other contracts.
• Additional Strategies: There are various other ways of short-selling if you need to go against a downtrend. Also, you can convert your asset to stablecoins, which are pegged with less volatile fiat currencies, or diversify your portfolio with assets from multiple backgrounds.

Risks Involved in Hedging

Usually, perfect hedges cannot be achieved because of the nature of the trading realm. So, there is always a risk element in hedging, mainly due to the uncertain movements in the charts. Let’s list the major risks.

• Sudden market fluctuations can cause a yin-yang between portfolio loss and profit in shorter intervals, creating sheer uncertainty.
• Engaging with futures and options requires larger trading fees than spot trading, and sometimes, brokerage costs will be involved.
• Some jurisdictions won’t allow short selling and the usage of futures. So, regulatory risk is involved.
• External risks such as liquidity issues, counterparty risks, and stablecoin peg failure can occur.

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The Bottom Line

As we mentioned at the beginning, hedging is a complex procedure, and one should exercise caution when engaging in it. Instead of getting involved in hedging, it is always better to conduct thorough research and invest in potential assets only. As a relatively new industry with recurring market fluctuations, always invest in crypto with caution.