First of all, what is hedging? It is a risk management principle employed to offset the investment loss by taking an opposite position in a related asset. Think of hedging as a form of investment insurance.
The question is how to protect cryptocurrency investments? Even though that the cryptocurrency market is relatively immature, there is already a small variety of available financial products that you can start using today to secure trading. In this article we will cover some of the hedging strategies.
I. Futures market
Bitcoin futures contract is the first traditional derivative product that officially entered the market through the established exchange, Cboe, back in 2017. With the emergence of futures trading, a new era has begun. Institutional investors from all over the world got an opportunity to short-sell bitcoin, which is something none could do before. Some analysts consider a short-selling feature of futures to be the main reason for the Bitcoin dramatic price plunge back in the year of 2018.
However, futures trading has been unofficially existing long before the Cboe and CME on various cryptocurrency exchanges, like Bitmex. Bitmex still remains one of the top market players with a tremendous daily trading volume. Many retail traders on Bitmex are trading with leverage up to 100x on a daily basis.
The most significant advantage of Bitcoin futures trading is that you don’t have to possess the underlying asset (bitcoin) to gain exposure to Bitcoin. CME is currently the only traditional exchange offering futures trading, whereas Cboe shut down futures trading desk due to insufficient liquidity and lack of financial interest in 2019. Bitcoin futures on CME are cash-settled, meaning that an investor receives cash instead of physical delivery of Bitcoin upon settlement of the contract.
This allows traders and investors to trade bitcoin without having any blockchain wallets with complex security features. As simple as that.
Another crucial advantage of Bitcoin futures is that you can use it for hedging your long positions in case the market starts falling. Imagine the next scenario: you have 1 Bitcoin on your Binance wallet that you purchased at $6000. As the time has passed, Bitcoin has reached the price level of $13000 and is now about to fall back to $10000 due to market selling pressure. You open a short position on a futures contract worth of 1 BTC to hedge Bitcoin that you’ve been holding since the date you bought it at $6000. Short-selling a contract worth of 1 Bitcoin allows you to secure your long position from a falling price of Bitcoin by 100%.
In other words, short-selling the market, you make a profit as the price is falling.
In the table above, you can see 2 scenarios. The first case is with a short-selling from $13000 when the price started to fall. The second scenario is a simple HODLING strategy from $6000 to the current market price without any hedging. Notice, that in the first scenario shorting the market from $13000 to $9000 with a futures contract worth of 1 BTC has resulted in a profit of $4000, which has offset the fall of Bitcoin, hence securing initial profit generated from $6000.
II. Options market
Bitcoin options market has emerged quite recently compared to the futures market. Deribit has been a primary supplier of options contracts through its online platform. Other companies that have options trading desks are LedgerX, Bakkt, OKEx, and CME.
The primary aim of options contracts is to provide traders and investors with the right, but not the obligation to buy or sell an agreed amount of Bitcoins on an agreed date. Due to the extreme volatility nature of Bitcoin, option prices are high and are mainly affordable for experienced market players. The biggest advantage of options trading is cost-efficiency due to leverage. Using a real example from Deribit, let’s make some simple calculations to spot the difference:
Instead of buying Bitcoin worth of $10000 right now, you can buy an option contract with only $838 that grants you an opportunity to buy 1 Bitcoin at $10000 price (strike price) at the settlement date. In this example, the 26th June 2020. Imagine that at the time of expiration (settlement date), the BTC price reaches $15000. You will lock-in a profit of $4162 ($15000-$10000-$838). Now let’s divide return on investment to get a ROI ratio. $4162 divided by ($838+$10000) and multiplied by 100% to get a percentage equals to 38.4%ROI. Now let’s compare option ROI to an ordinary spot trade ROI.
If you would buy Bitcoin on a spot market worth of $10000 and then sell it at $15000, the return is 5000$. To get ROI let’s divide a $5000 return by $10000 investment. ROI in this case is 50%. However, in option strategy you have only a risk of losing $838, whereas in spot trading you are exposed to market volatility and hence the loss is unlimited. Can you spot the difference now?
Professional traders and portfolio managers are using options for both speculative and hedging reasons. The example provided above is a simple Call option strategy. There is also a Put option strategy, which can be considered as a hedging instrument on a falling market.
The price of Bitcoin must fall significantly below the strike price before the expiration date for this strategy to be profitable. Let’s assume you purchased a Put option spending $1000 on it with a strike price of $10000 and by the expiration date, the price has fallen to $5000. In this case, the profit is $4000 ($10000-$5000-$1000). You exercised your right to sell BTC for $10000 when the current market price is 50% lower ($5000).
In case if you HODLING 1 Bitcoin, the profit generated by your Put option offsets Bitcoin’s price fall from $10000 to $5000. This is hedging!
III. Automated trading
Finally, one of my most favourite, easiest and affordable hedging strategies is automated trading. High-frequency trading mechanisms implemented in various automated bots allow making profits regardless of the market direction. Basically, you let the bot generate profits for you in a quote currency using the base currency. The idea is well-explained in our related article.
The biggest advantage of Bitsgap automated bots is that you can always stay in the market. Accumulated profit by the bot will automatically offset the negative value change in case the price of the base currency will start to depreciate. In the example below is a DATA/BTC cryptocurrency pair.
Imagine buying DATA at the price of 0.00000750 BTC (white box on the chart) and HODLING it without automated bot, which would otherwise use purchased DATA to accumulate profits for you in BTC by selling high and buying low each time the market swings. In this case, your ROI would be -4.01$ as indicated in the blue box. However, with automated bot ON the profit generated would offset DATA price drop.
Your ROI would be only -2%. In other words, you would hedge DATA from a higher loss. As the price of DATA then starts to revert back to its previous higher-high, with a base currency appreciation and the bot continued profit generation you will quickly get to a positive ROI.
Futures and options hedging is expensive in comparison to automated bot hedging. Traders and portfolio managers must accurately look for optimal entry and exit prices for hedging trades.
In the examples provided above, we assume that traders have entered into a hedging trade exactly at the point of trend reversal. In reality, the price can go in the opposite direction and the trader will have to bear the loss. For options hedging, the cost is the purchase of a contract. For futures hedging, the cost is an increased market exposure as the price of an asset is going in the wrong direction, which is an unrealized loss.
The beauty of automated trading is that it is trading for you on a 24/7 basis, accumulating profit regardless of the price direction. When the price is falling - it becomes a hedger. When the price is appreciating - it becomes a money machine.
Written by Dmitry Perepelkin