What is hedging, and how to use it?

Photo - What is hedging, and how to use it?
Hedging is a risk management strategy that a trader or investor employs by buying assets with an inverse correlation or opening an opposite position in a related asset.
The need for hedging arises during the investment portfolio drawdown and when the speculator begins to suffer losses due to an open position. Different assets are influenced by various factors, and with the right approach, the fall of one asset may be offset by the growth of another, which minimizes risks.

We have prepared an article on how to apply hedging in the cryptocurrency market.

Diversification as a risk mitigation strategy

Diversification refers to distributing funds from an investment portfolio across different assets. They should belong to different economic sectors and have distinctive pricing factors. Ideally, choose coins or tokens with an inverse correlation – when one cryptocurrency falls, another grows or remains flat.

For example, when retail investors lose faith in bitcoin and cryptocurrencies, they convert their funds into precious metals. Based on this, along with the crypto, it makes sense to keep gold stablecoins in the portfolio, for example, PAX Gold (PAXG), Tether Gold (XAUT), and others. The same goes for other areas.

After the FTX scam, many users began withdrawing money from CEXs to wallets. Thus, the tokens of centralized platforms sank, while the coins of DEXs and cryptocurrency wallets, on the contrary, grew by 150-200% in a few days.
Correlation of BTC and gold

Correlation of BTC and gold

Opposite margin trades

The best way to hedge an open trade is to open an opposite position on the margin or futures section. Suppose the purchased cryptocurrency is falling rapidly, and the trader realizes that the future market prospects are not favorable. In that case, it is logical to short the asset and minimize risks. Thus, with a further drawdown, the size of the user's capital will remain the same due to the profit overlapping from the second transaction.

By the way, this method is often used as a life hack to participate in several activities. Some launchpads or crypto projects give privileges to holders of their own tokens. It can be a cash reward, NFT, an allocation to a promising project, and other prizes. Traders resort to hedging to capitalize on an event with little risk.

For example, buying a coin for $1,000 and opening a short position for the same amount eliminates the risk of a token price fall. If the rate drops, the profit from a futures or margin transaction grows; thus, the capital loss is close to zero. At the same time, additional points are earned in the form of the listed items.

Cryptocurrency options

These derivative instruments give the owner the right to buy or sell an asset at a predetermined price. Options are similar to futures, but they do not oblige the trader to activate their contract but only give the right to do so.

The most commonly used hedging option is a put option. By buying it and having the underlying asset available, you can minimize losses in the event of a significant drop. The loss in this formula will be only a fixed premium that the issuer (seller) of the option will have to pay.

Recently, we have prepared a detailed guide on cryptocurrency options, describing the mechanism of their use for hedging and trading. Options are traded on many crypto exchanges, including Bybit, Deribit, OKX, Bitfinex, and Binance.

FTX was the best

The FTX crypto exchange derivatives section was filled with various hedging instruments. It offered cryptocurrency index portfolios, leveraged tokens, volatility contracts, and special Hedge coins, the prices of which grew with the fall in the underlying asset price. The scam of the platform not only exposed the exchange's massive manipulation of user funds, but also cut many trading opportunities that other exchanges have not yet fully recreated.