What is Hedging?

Hedging is a common risk management strategy in the financial sector aimed at reducing or offsetting investment risks. Whether in traditional finance or the realm of cryptocurrencies, the risks brought by market fluctuations are inevitable. Through hedging, investors can lessen the adverse impacts of market swings on assets. In the cryptocurrency market, where institutional oversight is lacking, market volatility is further heightened, leading investors to face greater risks. Consequently, they often employ hedging strategies to minimize these risks.
However, it is crucial to note that hedging itself incurs certain opportunity costs and, as it primarily seeks risk reduction, it may result in investors missing out on potentially lucrative opportunities, thus curtailing potential returns.

Principles and Process of Cryptocurrency Market Hedging

Hedging strategies come in a diverse range, but their fundamental principles remain consistent. Investors target a specific asset, establish a primary position, and then, based on their forecasts, open a position opposite to their current stance to balance out investment risks. The goal of hedging is not profit maximization; rather, it aims to ensure that if losses occur in the original risk exposure, the newly established risk position can generate profits to offset all losses. The principles of hedging in the cryptocurrency market mirror those found in traditional financial markets. Here is a basic overview of the hedging process in the cryptocurrency market:

1. Establishing Positions: Investors initially hold a certain amount of cryptocurrency assets, such as Bitcoin, Ethereum, or other tokens.
2. Identifying Risks: Investors must identify risks in the cryptocurrency market, which may include price fluctuations, market manipulation, regulatory uncertainties, and make rough estimates regarding these risks.
3. Establishing Contrary Positions: By selecting appropriate hedging tools, investors create opposing positions to mitigate the risks associated with holding cryptocurrency assets.
4. Monitoring and Adjusting: Regularly monitoring market developments, assessing the effectiveness of hedging strategies, and adapting them in response to market dynamics
   While hedging can effectively reduce risks, it also entails costs and, to some degree, restricts potential gains for investors. Therefore, hedging strategies are best suited for risk-averse investors.

Cryptocurrency Hedging Strategies

Hedging strategies in the crypto market share similarities with traditional financial markets but also involve specific considerations unique to the cryptocurrency domain. Here are some common cryptocurrency hedging strategies:

Futures Contract Hedging

Cryptocurrency futures contracts are financial agreements where both parties agree to buy or sell a specific amount of cryptocurrency at a predetermined price on a future date. Through futures contracts, investors can lock in future prices, enabling them to buy or sell cryptocurrencies at a fixed price regardless of market fluctuations.

Contract for Difference (CFD) Hedging

CFDs are financial derivatives that allow investors to engage in speculative trading without owning the underlying asset. Investors can profit from or incur losses based on asset price fluctuations without physically owning the asset. However, CFD trading involves high risk due to leverage amplifying potential gains and losses.

Options Hedging

Similar to futures contracts, cryptocurrency options grant holders the right (but not the obligation) to buy (call option) or sell (put option) a specific amount of cryptocurrency at a fixed price in the future or at expiry. By purchasing calls or putting options, investors can hedge against market price fluctuations by buying or selling cryptocurrencies at a predetermined price in the future.

Perpetual Swap Contract Hedging

Perpetual swap contracts are derivative contracts that track the price of an underlying asset without an expiration date. Unlike traditional futures contracts, perpetual swaps do not have a set expiry, hence the term “perpetual.” Investors can participate in the market through perpetual swap contracts without physically holding the underlying asset, utilizing leverage to increase positions. However, due to leverage amplifying potential gains and losses, perpetual swap trading involves high risk, requiring investors to exercise caution and understand related risks.

Stop-Loss Order Hedging

Stop-loss orders are automatically executed orders when the market price reaches a pre-set level, aiming to limit potential losses for investors. By setting stop-loss prices, investors can minimize losses to a manageable extent. It’s essential for investors to carefully set stop-loss levels and continuously monitor market conditions to ensure the effectiveness of their stop-loss strategy.

Short Selling Hedging

Short selling involves selling borrowed assets with the intention of buying them back at a lower price in the future to profit. Investors can earn profits from market declines through short selling, offsetting losses from other asset declines. However, short selling carries inherent risks, as investors face exposure risk if asset prices rise.

Stablecoin Hedging

Investors can mitigate the impact of cryptocurrency market volatility on their portfolios by converting cryptocurrencies into stablecoins like USDT or USDC. Stablecoins are typically pegged to a stable asset (e.g., the US dollar) or a basket of assets, maintaining a relatively stable value and providing a degree of protection during market fluctuations.

Common Hedging Strategy Examples

In practical applications, people often use futures contracts, contract for difference (CFD), and options strategies for risk hedging. Here, we provide examples of these three types of hedging strategies to demonstrate their practical implications.

Futures Contract Hedging Example

Background
Assuming an investor holds 1 BTC at the current market price of $50,000 and is concerned about potential price drops.
To hedge the risk, the investor opts to short a Bitcoin futures contract expiring in a month at a contract price of $49,500. If the Bitcoin price falls, the value of the short contract will rise, offsetting the risk of the actual Bitcoin position’s value decline.
Price Movements
Scenario 1: Bitcoin price drops to $45,000
Actual Bitcoin position loss: $5,000
Short contract profit: $49,500 - $45,000 = $4,500
Net loss: $5,000 - $4,500=$500
Scenario 2: Bitcoin price rises to $55,000
Actual Bitcoin position value increases: $5,000
Short contract loss: $55,000 - $49,500 = $5,500
Net loss: $5,500 - $5,000=$500
Conclusion
By shorting Bitcoin futures contracts, investors can partly hedge the value loss of their actual Bitcoin position when prices drop. However, during price increases, hedging through short contracts may lead to losses, offering no additional gains.

Contract for Difference (CFD) Example

Background
Assuming an investor holds 1 BTC at the current market price of $50,000 and is concerned about potential price drops.
To hedge the risk, the investor purchases a 2x leveraged CFD for 1 BTC.
Price Movements
Scenario 1: Bitcoin price drops to $40,000
Actual Bitcoin position loss: ($50,000 - $40,000) = $10,000
CFD value: ($50,000 - $40,000) 2 = $20,000
Total profit: $20,000 - $10,000 = $10,000
Scenario 2: Bitcoin price rises to $55,000
Actual Bitcoin position value increases: ($55,000 - $50,000) = $5,000
CFD loss: ($55,000 - $50,000) 2 = $10,000
Total loss: $10,000 - $5,000 = $5,000
Conclusion
Investors can hedge against Bitcoin price drops through CFDs. Opening a short CFD position in anticipation of a price drop can help investors profit from declines, offsetting potential losses from holding actual Bitcoin. However, under leverage, continuous market monitoring and risk management are crucial to promptly close positions in case of unexpected market movements to avoid significant losses.

Options Hedging Example

Background
Assuming an investor holds 1 BTC at the current market price of $50,000 and is concerned about potential price drops.
To hedge the risk, the investor buys a one-month put option contract for Bitcoin with a strike price of $45,000, costing $600.
Price Movements
Scenario 1: Bitcoin price drops to $40,000
Actual Bitcoin position loss: ($50,000 - $40,000) = $10,000
Put option value: ($45,000 - $40,000) = $5,000
Net loss: $10,000 - $5,000 + $600 （option cost）= $5,600
Scenario 2: Bitcoin price rises to $55,000
Actual Bitcoin position value increases: ($55,000 - $50,000) = $5,000
The put option will not be exercised, and the investor only loses the option cost of $600.
Conclusion
By purchasing put option contracts, investors can partially hedge the value loss of their actual Bitcoin position in case of price drops. In the event of price increases, the hedging cost is limited to the option fee.