EMX Trading Series: Hedging with Derivatives

Posted by EMX Team on Oct 2, 2019 12:49:37 PM

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In this blog post and video, EMX co-founder and CTO Craig Austin shows you step-by-step how you can use EMX to hedge your portfolio, helping to minimize losses from your positions while maintaining your chance at upside. We recommend that you watch the entire video to see how to hedge your positions on EMX. 

As a holder of Bitcoin, you're most likely comfortable speculating that the price of Bitcoin will rise over time. However, this opens you up to risk: If the price of Bitcoin drops, you lose money. To reduce the downside risk of holding Bitcoin, you can hedge

Hedging means to partially or fully offset the risk incurred by holding some position. You can protect yourself from downside by trading derivatives on EMX. Your derivative positions can help offset losses if the price of an asset you hold goes down (or up).

For example, let's say you hold 1 BTC in your Bitcoin wallet, and it's currently worth $10,000. If the price of Bitcoin goes down $100, you lose $100. You aren't hedged, so you lose the full $100.

Now, let's say you make an agreement with another trader who is willing to buy your 1 BTC in six months at the current $10,000 price, no matter what. At that point you'd have eliminated the risk associated with holding your BTC. You'd have 1 BTC in your wallet (currently worth $10,000) and a contract to sell that BTC at $10,000 in 6 months. This contract is a hedge — and the agreement between you and the other trader is a form of futures contract.

While this would protect you from risk, it's important to also know that hedging can eliminate profit potential. If the price of Bitcoin appreciates significantly over the next six months, to $12,000, locking in the current price ($10,000) for the future sale would turn out to be a bad trade since you'll miss out on $2,000 in profits.

You can hedge on EMX by going short a derivative contract tracking or correlated to an asset you are holding, in this case Bitcoin.

How to hedge your portfolio

Let's say you own 1 BTC, and you want to hedge your portfolio.

What you need:

  • An account on EMX.
  • Bitcoin for depositing on EMX.
Steps to take:
  • Log in to EMX and deposit funds.
  • Choose the futures contract or perpetual swap contract applicable to your holdings; in this example, we can use BTCZ19 (the December 2019 Bitcoin Future).
  • Calculate the number of contracts you need to match your holdings; in this case, 1 BTC-PERP or BTCZ19 contract.
  • Sell ("short") 1 contract of BTCZ19 using the order entry ticket.
  • Close this position when you want to end your hedge.

Why you should hedge your positions

There are many benefits to hedging your positions with futures on EMX:

  • Derivatives have implicit leverage, so you don't need as much capital for hedging as you would need to devote to your spot positions — though you will need to monitor your margin levels to avoid liquidation.
  • You know the cost of your hedge as soon as you place it:
    Hedge Cost = Transaction Fees + Premium/Discount of the Futures Contract (relative to the underlying asset you're hedging)
  • If you use a post-only limit order to place your hedge, you can make back 0.03% of the transaction fees you pay, for additional earnings (only on EMX).
  • You do not need to convert to fiat/USD; you can continue to hold your crypto while managing your exposure trading derivatives.

When to hedge with futures vs. perpetual swaps

You can use both futures and perpetual swaps on EMX to hedge. The use case for each varies. To understand more about perpetual swaps, click here.

Advantage of hedging with futures:

  • The cost of hedging is more predictable, and you don't have funding rates to worry about. Fluctuating funding rates (these change every 8 hours on EMX) will vary the cost of maintaining your hedge. Depending on the funding rate, you may end up paying (losing) to maintain your hedge using perpetual swaps - or you could profit if the funding was in your favor.

Advantages of hedging with perpetual swaps:

  • No need to worry about expiry dates. (Futures expire monthly or quarterly - but perpetuals never expire.)
  • Less likely to have significant deviations to spot prices. (The short funding period for perpetuals means they will track the underlying prices closer than the futures, in most cases.)
  • Generally more liquid than quarterly futures, so liquidity / slippage shouldn't be as much of an issue.

Conclusion

Hedging can be a powerful strategy for limiting risk. You might not make considerable returns from it, but it's a tool you can use to quickly, easily, and cheaply shift exposure in your portfolio to limit downside - or translate exposure from one asset to another.

It is also important to acknowledge the risks of hedging; it's not a cure-all. Prices can swing widely on a daily basis, and if you are over-levered this can still be dangerous due to hedges being imperfect, or expensive to maintain. You should continually monitor your derivatives exposure.

EMX provides the most diverse collection of derivative products in the market for hedging. You can hedge all kinds of assets, from gold to US equities, from Bitcoin to Chainlink, and use both futures and perpetual swaps to do so. Hedging on EMX is best suited for traders who don't want to convert their cryptocurrency holdings to fiat.

Start hedging your assets on EMX today!

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Topics: Education, Trading Series