Three Ways to Hedge Risks in Crypto Trading
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Good investors know opportunities. The best investors understand risks.
Don’t bet all your chips on just one thing – this is an investing rule of thumb most have learned on day one. Yet, to beginners, spreading the risks out is often easier said than done. In a place as volatile as the digital asset market, what can you do to protect yourself while the market trend is on the downside? Here are some hedging strategies you need to know.
What is hedging?
First things first, you need to understand that hedging is a way of mitigating risks against market volatility rather than making a profit. By hedging, you cannot make a considerable return out of it, but maintain a stable value of your asset portfolio over undesirable market conditions.
Simply put, hedging is a risk-minimizing strategy typically by taking an offsetting position on one’s primary asset. There are three common ways that you can hedge your digital assets.
1. Diversifying your portfolio
Commonly touted as the don’t-put-all-your-eggs-in-one-basket strategy, diversification is arguably the simplest way to hedge exposure. However, unlike the traditional stock market, which spans across an extensive array of industries and asset classes, the digital asset market is comparatively monotonous.
When formulating your diversification strategy, you must keep in mind that most digital assets are relatively volatile, and the overall market tends to move together to one direction. In order to offset the risks associated with altcoins, you may need to consider adding to your portfolio with reputable coins. After all, diversification is all about maintaining healthy mix of assets. It may take you a few trials to find out the right combination for yourself.
A more advanced means of hedging is short-selling. This method may protect you from an unexpected downturn of asset price when you expect the asset price to go up. It can be done by selling a digital asset borrowed from an exchange, such as through margin trading. Simply put, you can sell to open a position and buy it back later at a lower price and keep the difference as a gain. With margin trading, you may make use of a leverage of up to 5x to maneuver this action.
For example, you were optimistic about Bitcoin (BTC) and holding a certain amount of it, but at the same time wanted to hedge a downturn risk. Therefore, you could open a margin trading position to borrow one BTC and sell them (say, at 5,500 USDT) right after. In case the BTC price dropped, you could buy back one BTC at a lower price (say, at 5,200 USDT) and repay the margin lending. As such, the 300 USDT difference will cover your loss from your BTC holding.
However, you should note that hedging with short-selling comes with a certain cost, such as margin interest and transaction fees. You should do some calculation beforehand to find the right balance between your holding and hedging positions.
3. Making use of derivatives
Derivatives are widely utilized as hedging instruments in traditional stock markets. Common derivatives include futures, swap, options, and forwards, etc. As its name suggests, their prices are derived from and determined by fluctuations in the underlying asset. Stocks, bonds, commodities, currencies, interest rates, and market indexes are the most familiar underlying assets.
In the digital assets market, although the overall development of derivatives is still in its infancy stage, some exchanges have been providing derivative products in the market, including futures and perpetual swaps, allowing users to trade both at one place.
A futures contract, for example, is an agreement to buy or sell a particular asset or commodity at a predetermined price at a specified time in the future. In the crypto space, while futures are frequently used by miners to guarantee the value of the cryptocurrencies they will mine out, traders, of course, can also make use of the derivative to hedge exposure and reduce the potential for losses caused by unexpected market movements.
Maneuver wise, let’s say you expected BTC to reach $8,000 by a certain date. You could buy a contract with that “strike price.” If the BTC price hit that target, you would gain. If not, you would lose the price you paid for the contract. On the contrary, you may do the opposite to short BTC to offset the loss in case the BTC price goes down.
Do manage your risks carefully
Despite their utility in risk hedging, short selling and derivatives increasingly tend to be prompted by speculations nowadays. Here, we only introduce these tools and strategies as risk hedging methods. Since the risk of losses on a short sale or derivative is theoretically unlimited, you are advised not to trade for speculation, and should only make investment decisions when you are familiar with the risks associated.
Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involves significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.
OKEx is a world-leading digital asset exchange headquartered in Malta, offering comprehensive digital assets trading services including token trading, futures trading, perpetual swap trading and index tracker to global traders with blockchain technology. Currently, the exchange offers over 400 token and futures trading pairs enabling users to optimize their strategies.