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In one of my previous posts, I touched upon how you can use futures contracts to protect your cryptocurrency positions. Here, I will expand on the concept of ‘hedging’ and guide you through some use cases on how to utilize futures trading to add depth to your strategies.
Hedging refers to the practice of limiting your exposure to adverse price movements. For hundreds of years, traders have utilized futures to protect against unexpected changes in the cost or value of a product. In a way, hedging is like taking out an insurance policy on your physical crypto assets.
The cryptocurrency markets are well suited for hedging. Bitcoin and other cryptocurrencies have been subject to high volatility over the past nine months. Just last week, the price of BTC shot up $600 in a half hour.
For those investors that aren’t so keen on stomaching the market’s wild rides, hedging can help provide stability for your cryptocurrency portfolios. .
Using ‘short’ hedges for protection
There are two common types of hedging, which refer to the market direction they seek to protect against. The first is a ‘short’ hedge, which is designed to help protect against the risk of sharp decreases in value. The second is the ‘long hedge’ which I expand upon later in this post.
For a ‘short’ hedge, you would sell a futures contract equal to or a portion of the total value of your actual cryptocurrency position (remember, you aren’t buying or selling the actual asset in a futures contract) for a specified price at a predetermined time in the future.
Here is an example:
Let’s say you hold 10 BTC which you bought at $7,000. You want the ability to sell your BTC in three months’ time and buy altcoins. But you are concerned that the price may drop over the next few months, giving you a loss — and less capital — if you choose to sell.
You decide to sell 10 futures contracts for 1 BTC each at $7,500 per contract` to hedge your BTC holding.
After three months, the price of Bitcoin has dipped to $6,000. Without the hedge, you are looking at a $10,000 loss ($1000 per contract * 10 contracts).
In the futures market, you are selling the value of 10 BTC to another investor at $7,500. You are looking at a gain that, in effect, makes up the difference between the current market value of your position and the price you originally paid for the 10 BTC.
The hedge is ‘cash settled’, which means that one party pays the other party the difference between predetermined value (initial price at which the trade was initiated) and the current market value. Thus, in this scenario, the investor on the other end of this contract would pay you the $15,000 difference. (If this were a physically deliverable contract you would actually sell 10 Bitcoin to the other party and receive $75,000.)
It’s worth noting again you haven’t actually sold your BTC position, you’ve simply hedged your exposure. So you could elect to hang onto the coins longer — or, if you wanted to sell, the $15,000 difference would make up for the losses of selling at $6,000, preserving your capital.
One more thing to mention: though the futures contract has a predetermined expiration date, you can close out the contract and lock in your gains at anytime before that date. All you have to do is buy or sell a contract that exactly mirrors the futures position that you’ve previously purchased. In this example, that would mean buying 10 contracts of 1 BTC each at $7,500 per BTC. When a trader has an identical buy and sell positions, the clearing house simply closes the position and calculates your gain or loss.
Using ‘long’ hedges for timely buying
Alternatively, you may want to lock in the price of a cryptocurrency to protect future purchases from an unexpected spike in prices. This would be considered a ‘long hedge.’
In a ‘long hedge’, you would buy a contract that enables you to buy the value of a predetermined cryptocurrency position at a future specified date.
Let’s say you wanted to liquidate (sell) five BTC at $6,000 each to buy into an upcoming ICO, with the intention of eventually selling that altcoin in the future to buy BTC back. However, you were concerned about the price of BTC spiking to $9,000 over time, potentially giving you less BTC when you sell the altcoin (especially if the altcoin doesn’t perform to expectations).
If the price of BTC did indeed move up to $9,000, you would be looking at a net loss of BTC without a hedge:
With a long hedge, you could lock in an agreement to buy five BTC at $6,000 at a predetermined future date, no matter what the actual market value of Bitcoin ends up being.
Once again, the futures contract is “cash settled”, meaning that you collect the difference in the contract value versus the actual market price. The proceeds of your long hedge would make up for the upward movement in the BTC price, protecting your purchasing power.
Once again, the futures contract can be closed out before the expiry date. In this instance, you would sell an identical futures (5 BTC contracts) position to offset your buy, effectively netting your position.
It’s never a sure thing
There are two sides to the coin when it comes to futures. When you buy or sell any futures contract, there’s always another trader on the other side of that agreement. That trader is anticipating the opposite to happen. In the short hedge example listed above, the individual buying your short hedge is hoping that the price of BTC will be higher when the contract expires or they close their position, which can happen in seconds, days or months — anytime before the futures contract expires.
Sometimes, the markets move in a different direction than you expect. In the case of the short hedge, if the price of BTC went above $7,500 at the time of expiry, your contract would, in effect, generate a net loss. This is because you’re selling the value of 10 BTC at a price that’s lower than what the current market price.
This is a way of saying — no hedge is a guaranteed to ensure an optimal outcome. Selecting a hedge that suits your investment strategy requires some research, timing and a solid understanding of what drives the cryptocurrency markets.
One platform, numerous ways to hedge
As the cryptocurrency world expands and new coins hit the market, the opportunities for hedging will also grow. EMX is designed to be your one-stop-shop for trading cryptocurrency futures. Over time, EMX will provide more futures contracts for more coins than any other exchange in the marketplace.
Already, hedging has proven to be a viable approach for early adopters in protecting the value of their BTC positions through what has been a rocky six months. As word of these successes spreads in the community and as more traders become familiar with the use and value of cryptocurrency futures, we can expect hedging to feature more and more within trading strategies.
Futures and options trading involves substantial risk of loss and is not suitable for all investors. Investors should understand the risks involved in trading and carefully consider whether such trading is suitable in light of their financial circumstances and resources. Past performance is not necessarily indicative of future results.