5. Introduction to Crypto Hedging: Options, Futures and Diversification
This piece is written by @captainJack from Phezzan Discord server
One trait that often follows the mention of cryptocurrency is its volatility. Owing to the novelty of the asset class, it is understandable that it is rife with unprecedented volatility. This has earned the asset class its position at the far end of the risk spectrum. The risk associated with this volatility has been spoken about ad nauseam by the mainstream media, and it stands to reason that this echoed sentiment is a major contributor to investors avoiding the asset class. However, there are many ways to mitigate the risk associated with Cryptocurrency investment, and one of these is hedging.
What is hedging?
Hedging in its simplest form is a risk management strategy. This is the approach of taking an opposite position of a related asset to offset losses. It is a long-standing strategy applied by all kinds of investors, from individuals to large institutions, to reduce their exposure to potential losses. Hedging generally involves trading the opposite direction of the asset being hedged against or trading the same direction of another asset that moves inversely to the hedged asset.
A common example of hedging is the purchase of gold against the US dollar. Investors buy gold as a hedge during times of inflation, due to gold maintaining its value when the dollar falls. It is worth noting that, as the risk is mitigated, the potential reward is inherently capped. The higher the risk, the higher the reward; the lower the risk, the lower the reward.
Common hedging strategies
Hedging strategies mostly involve the use of derivatives. Derivatives are financial instruments that derive their value from an underlying asset, group of assets, or benchmark. A firm understanding of derivatives is the first step to understanding hedging techniques and how to successfully implement them.
Options are financial derivatives that give the buyer the right to buy or sell the underlying asset at a specified price within a window of time. For example, assuming you wanted to buy BTC because you thought the price would go up, but wanted to protect your portfolio against any loss should the price crash. You would buy a BTC option (put option) that gives you the right to sell your BTC at the same price you bought it. This usually comes with a small fee referred to as a premium.
Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Futures are similar Options with the differential of “obligation to transact”. Futures contracts facilitate investor speculation on the direction of an asset. There are several kinds of Futures contracts, to be more specific to crypto - term futures (also called the traditional futures) and perpetual futures.
Perpetual futures differ from term futures in that they lack pre-specified delivery dates and this allows them to be held indefinitely. Both types of futures can be traded on centralized or decentralized platforms. SynFutures v2 has both types of futures contracts to fit the needs of different investors. Cryptocurrency investors can fend off risk to their portfolio by purchasing a futures contract without being time-bound.
Diversification as a hedging strategy is simply investing in uncorrelated assets in a portfolio. This way investors mitigate the risk of losing their whole portfolio if one asset experiences a bear market. An example of this is investing in real estate and tech stocks. This way, the investor’s portfolio doesn’t bear the full brunt of a bear in either asset class.
Advantages of Hedging
Hedging is a great way to mitigate risk.
Hedging protects investors during times of uncertainties in the market. Market liquidity is boosted as a consequence of the increment of liquidity providers.
Hedging guarantees psychological stability by reducing the amount of time and effort spent on portfolio management, especially in times of volatility.
Disadvantages of Hedging
Hedging inherently limits potential reward, as risk and reward are often proportional to each other.
Successfully implementing hedging strategies requires a relatively higher level of expertise and experience.
Hedging is a well-known practice in traditional finance, particularly amongst large investors and institutions. Its lack of popularity amongst retail investors is largely due to its costly and high-skill demanding nature. This is a barrier that has been bridged with the advent of blockchain technology and cryptocurrency.
Financial instruments like perpetual futures have opened this once esoteric concept to the mainstream. Furthermore, the emergence of DeFi continually introduces new use-cases for the technique. This is a trend that is poised to grow as the financial milieu evolves with time.