The cryptocurrency industry operates like the traditional finance space in several forms. One of them is the fact that investments carry risks.
You can learn about trading from the masters all you want, but crashes happen unexpectedly and can take your holdings out. You need a way to maintain your safety while you’re treading the trading waters, and you need a reliable strategy to keep you afloat.
Thankfully, there are different hedging strategies that allow you to maintain your safety and operate within the required parameters.
Types of Hedging Techniques
Short-selling is essentially the practice of taking a trading position to offload an asset. In this case, the trader believes that the asset’s value will fall, so that he can buy it back for a lower price and make a profit off the margin between both prices. When it comes to long exposure in cryptocurrency trading, there’s hardly any form of hedging as effective as this.
Traditionally, short-selling involves borrowing a cryptocurrency from a broker or some other party and selling it on the open market. Some exchanges allow this to happen. However, it can be a tad challenging to find a third party that will want to lend you the assets. Most times, even if you do find a lender, there’s always the chance that they can recall their asset whenever they can.
For instance, if you borrowed one Bitcoin to short-sell when the market was at $5,000, and the asset’s value increased to $6,500, your losses are piling up.
Hedging by diversification usually happens through the gradual fixation of profits and making replacements on the asset’s portfolio. However, for this to work, the asset will need to have an inverse relationship with the specific cryptocurrency price.
Margin trading allows a trader to borrow assets from a trading platform. By providing security and capital, the platform borrows the trader tokens and allows him to sell them. When the asset’s price drops, the trader can buy again and make profits.
By its inherent nature, margin trading can be used as a hedging instrument. The system works well primarily with Bitcoin, although it is a lock for any investor who fears a possible drawdown in their portfolio.
The expected drop in price can open a new short position, allotting the investor to reduce losses while selling his cryptocurrency for fiat.
This hedging method allows a trader to calculate the maximum possible percentage of a possible drawdown in their portfolio.
However, the system is also significantly flawed as it would only work if the trader to store assets in their account on a trading platform.
By knowing an asset’s current price, a trader will be able to set the maximum drawdown price allowable to establish the conditional order. Then, it will sell the assets that the trader determines in the market when the asset falls below such a specified level.
Despite the presence of ordinary trading options, the crypto market is still nascent. This means that it has relatively low liquidity levels – a feature that makes hedging inherently difficult.
Perpetual swaps have grown recently in popularity, thanks to the fact that more exchanges have begun to offer them. Their use is pretty similar to that of inverse futures. However, the difference lies in two points:
- They have a periodic funding date
- Perpetual swaps also don’t have an expiration date
The primary reasons to use perpetual swaps are essentially the same as why you would hedge with futures. Perpetual swaps are cost-effective ways to hedge out your risk, primarily because of the following:
- You can get high leverage, meaning that you will have a lower capital requirement. Note that you would have to meet the stated margin requirements.
- Depending on the market conditions, you could even profit over time from the hedge
- You know how much your hedge costs
Even better is the fact that perpetual swaps can track the underlying prices of an asset closer than futures. By not having to deal with rollovers, you also don’t have to handle high trading costs.
If you’re looking for a means to hedge your coins and exposures in a more efficient way, perpetual swaps are a great option for you. However, they can be pretty complicated, and you will need to know more about them to use them.
Factors to Consider When Hedging Cryptocurrency Risk
Diversification is one of the most popular means of reducing cryptocurrency trading risk in the market., With diversification, you get to maintain a healthy mix of assets.
There are many industries represented in the traditional stock market. By diversifying, you can hold stocks in different industries and ensure that crashes in one don’t necessarily affect your ability to trade or your bottom line. Since the holdings in other industries are solid, you can survive.
Remember that most trading pairs in the crypto market are pretty volatile. If you would like to maintain safety, you will need to diversify. You can have a portfolio of different coins, including Bitcoin, Ether, Ripple, and more. These are pretty volatile, making them perfect candidates for hedging against risks in other cryptocurrencies.
The second consideration will be to have an account on an exchange that will allow you to hold money in fiat currency – along with cryptocurrencies. This will make for more effective money transfers and will help you to reduce being stranded if a major crash happens.
Higher liquidity will also help you to take quick advantage of optimal exchange rates that happen in your favor.
Use of Options and Futures
These are called crypto derivatives. You will need more capital, advanced knowledge of trading, and the possibility of carrying more risks. Also, only a few sites allow you to hedge cryptocurrency risk using options or futures.