What is Hedging and How does it work?

Hedging is an investment strategy that involves taking offsetting positions in different financial instruments to limit loss or gain. For example, a hedge fund manager might buy stocks and also purchase put options on those stocks as a hedge against a drop in the stock market. While hedging can help protect against losses, it can also limit gains if the market moves higher. As such, hedging is often used as a way to manage risk rather than to generate returns. This article will offer detailed insights on hedging in cryptocurrency.

Different Hedging Strategies

Hedging by Diversification

Cryptocurrency investors can hedge their portfolios against volatility and downside risk by diversifying their holdings across different asset classes. One way to do this is to invest in a mix of different cryptocurrencies, including major coins like Bitcoin and Ethereum, as well as lesser-known altcoins. Another way to diversify is by investing in cryptocurrency-related assets such as utility and blockchain platform tokens. By investing in various asset classes, investors can minimize their exposure to any single risk factor. Additionally, portfolio diversification can help smooth out returns over time, providing a steadier income stream even during market turbulence periods.

Hedging by Short-selling

Many investors choose to hedge their cryptocurrency portfolios by short-selling assets. Short-selling is a way to bet against the price of an asset if you think the price will drop, and it can be used to offset the risk of potential price declines. Short-selling assets can be a great way to hedge your bets against market volatility.  

For example, let's say you think the price of Bitcoin is going to drop in the next week. You could sell your Bitcoin now and then buy it back at a lower price next week. If the price does indeed drop, you will make a profit. However, if the price goes up, you will lose money. Short-selling assets may be challenging, and it requires a lot of research and knowledge about the market. You also need to be comfortable with taking on some risks.

Hedging With Options

Hedging options is a great way to protect your investment from unforeseen circumstances when trading. By buying an option, you are essentially buying the right to buy or sell an underlying asset at a certain price on or before a certain date. If the price of the underlying asset moves against you, the option will increase in value, offsetting some of your losses. There are two main types of options - call options and put options. 

Call options give you the right to buy the underlying asset, while put options give you the right to sell it. When hedging with options, you will need to choose which type of option is best suited to your needs. For example, if you are worried about a sharp decline in the price of Bitcoin, you might buy a put option that gives you the right to sell Bitcoin at its current price on or before a certain date. If the price of Bitcoin does fall, you can exercise your option and sell your Bitcoin at the strike price, limiting your losses. This type of hedging is one of the most effective ways of limiting losses and minimizing risk.

Hedging With Futures

Cryptocurrency futures are financial contracts that allow two parties to agree to buy or sell a digital asset at a set price at a future date. Cryptocurrency futures can be used to hedge against price movements in the underlying digital asset. For example, if you expect the price of Bitcoin to fall, you could sell a Bitcoin futures contract. If the price of Bitcoin falls as you expect, you will make a profit on your futures contract. If the price of Bitcoin rises, you will incur a loss. Cryptocurrency futures can also be used to speculate on future price movements. For example, if you expect the price of Bitcoin to rise, you could buy a Bitcoin futures contract. If the price of Bitcoin rises as you expect, you will make a profit on your contract. If the price of Bitcoin falls, you will incur a loss.

How are Hedging Futures Different From Hedging Options?

The main difference between hedging with futures and hedging options is that in hedging with futures, the trader benefits from a single direction movement of the trade, either up or down. Hedging with options, on the other hand, ensures that the trader can benefit when the trade moves either up, down, sideways, up then down, and so on. In short, options, as the name suggests, have more options and are versatile as compared to futures.

Another key difference is that with options, you can perform a long trade that will increase the potential for gains in the trade depending on the options you choose. Additionally, since payments are made upfront the potential loss is known, reducing uncertainty and making it easy to manage your funds.

Lastly, future contracts have obligations to buy or sell an asset, while with options, the buyer will have the right to buy or sell an asset at a given price but not the obligation to do the same.

Bottom Line

Hedging in cryptocurrency is primarily done to ensure digital assets are protected against the risk of price changes. By investing in a variety of cryptocurrencies, you reduce your exposure to volatility and maximize your chances of seeing returns. In addition, hedging can help you take advantage of opportunities as they arise. For example, if the price of Bitcoin falls sharply, you may be able to buy it at a discount and then sell it later when the price recovers.