How to hedge bitcoin risk
As cryptocurrencies continue to gain attention, traders have begun finding ways of protecting their bitcoin holdings from risk. Find out how to hedge bitcoin risk – including three cryptocurrency hedging strategies.
What are the risks of trading cryptocurrencies?
There are a variety of reasons that cryptocurrencies, such as bitcoin (BTC), are considered risky. These include:
- Lack of regulation. As cryptocurrencies are decentralised, banks and governments have yet to understand how best to protect traders and investors who choose to buy and sell the assets. The decentralised nature of bitcoin has thrilled its supporters, but it could create legal and taxation issues as it grows in popularity
- Susceptibility to hacking. A considerable number of cryptocurrencies are stolen from digital wallets every year. In 2018 alone, it is estimated that $1.7 billion worth of cryptos were stolen and there is rarely a way to retrieve these losses
- Reliance on technology. Bitcoin and other cryptos are completely digital assets, which means that they are essentially worthless without access to technological resources. With gold, real estate or even shares, you are gaining ownership over something that can be exchanged, whereas cryptocurrencies have no collateral backing them up
- Market volatility. Cryptocurrencies are notoriously volatile, both in intraday trading and over longer periods. For example, bitcoin’s price experienced a sharp spike in December 2017, reaching a high of $19,763.50, before falling to a low of $3126.29 in December of the following year
However, for those keen enough to learn, there are ways to reduce the risk you take on, at least to a known amount. This is where risk management tools, such as stop-losses, and strategies, such as hedging come in.
How to hedge bitcoin
Hedging bitcoin, or any cryptocurrency, involves strategically opening trades so that a gain or loss in one position is offset by changes to the value of the other position.
Generally speaking, if you’re concerned about the risk to your position, it is probably safer to reduce your position size or close your position completely. However, hedging is seen as a useful strategy for traders who want to maintain their original bitcoin holding but create a neutral exposure. There are a variety of ways to achieve a cryptocurrency hedge, but three popular methods are:
Short-selling in general is the practice of taking a position to sell an asset, believing that it will fall in value and you can buy it back for a lower price – profiting from the difference.
Short-selling bitcoin is a common hedge against a long exposure, whether this is a bitcoin holding or a speculative trade. If you already own bitcoin, but believe it is due to fall in the short term, you might decide to reduce your exposure by opening a short position on the cryptocurrency at the same time. This way, if the market falls, you can cover some of the loss to your initial position with gains on your short position.
The traditional method of short-selling would involve borrowing bitcoin from a broker or third party, selling it on the open market, and then returning the coins to their owner. There are a few cryptocurrency exchanges that facilitate short-selling, but it can be difficult to find a third party that is willing to lend you the asset. Even if you do find a willing lender, they are able to recall their asset at any time – this could mean you would have to buy the coins back for a much higher market price.
For example, let's say you borrowed a bitcoin to short-sell when the market price was $10,000. But instead of falling in value, the price increased to $12,000. You would have to buy the bitcoin back at the higher market price and would have taken a $2000 loss.
Most short-selling of bitcoin is performed using our other hedging methods: CFDs and futures.
Hedging bitcoin with CFDs
One of the most popular ways to hedge bitcoin is through CFD trading. As derivative products, you would not be required to own the underlying cryptocurrency in order to open a position. This means that you can speculate on the price of bitcoin without ever having to worry about opening an exchange account or digital wallet.
Another benefit of derivatives is that you can take advantage of markets that are falling in price as well as those that are rising – essentially, they enable you to short-sell without having to borrow bitcoin. This is a particularly important feature for hedgers, who need to be able to protect themselves against declining assets.
There are plenty of strategies that you can implement using derivatives but one of the most popular is direct hedging. This involves taking two positions on the same cryptocurrency, at the same time, but in opposite directions.
Let’s say you owned two BTC and, although you believe in the long-term potential of the technology, you believe that short-term volatility could impact your position. Rather than selling your bitcoins, you decide to hedge against them. You open a CFD trade to short bitcoin. Once any negative price movement is over, you could close your direct hedge, and the profit to the CFD trade would offset the loss to your cryptocurrency holding. And if the price of bitcoin didn’t decline, then the profit to your holding would offset any loss to your bitcoin CFD.
Hedging bitcoin with futures
Bitcoin futures were first introduced in 2017, by the Chicago Board of Options Exchange (CBOE) and later by the Chicago Mercantile Exchange (CME). Futures are a type of financial contract in which two parties agree to trade an asset, in this case bitcoin, at a predefined price on a specific date in the future. Bitcoin futures are seen as providing a legitimate way for market participants to lock in a market price.
Let’s say you own one bitcoin, which is currently worth $10,000. By selling 10,000 futures contracts (each with a contract size of 1 USD), you are essentially ensuring that you will trade your bitcoin for $10,000 in the future, regardless of what happens in the underlying market. If the market did fall, let’s say down to $9000, your futures position would be $1000 in profit. If the price of bitcoin increased instead, up to $11,000, you would be obliged to sell your bitcoin for $10,000.
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