Key Takeaways

The cryptocurrency market is essentially not much different from the stock market. Hedging was also taken over from him. The key attraction of the strategy is investing in alternative assets like hedged bitcoin to compensate for negative fluctuations in value. Thus, you will always remain in the black despite the market behavior. This is a kind of insurance that can reduce the drawdown to a minimum. Hedging crypto requires certain expertise like understanding how to use crypto derivatives exchange.

What is Hedging?

Hedging is one of the main risk management tools. It is aimed at protecting the trader from unforeseen fluctuations in the market such as default, rate collapse, and economic instability. In other words, hedging is a range of methods and strategies for compensating for unprofitable positions at the expense of profits from other positions.

There are many tools for hedging risks, you can use any. In this article, we will talk about the most effective ones. Without hedging strategies, traders would periodically and unpredictably find themselves in a situation of having to close positions and take losses in the face of market uncertainty. Anyone can start hedging no matter what exchange one is using: Redot, Coinbase and so on.

Why Hedge Cryptocurrency?

Of course, one of the main questions is why adopt hedging in cryptocurrencies. Firstly, the cryptocurrency market is very unstable, and this is not a secret for everyone. Prices can rise sharply in a matter of hours and fall the next day. This was the case with Dogecoin at the beginning of 2021. For many, volatility is a way to make money. However, this is a huge risk of loss.

Another reason to use hedging in cryptocurrency is decentralization. Cryptocurrency does not have regulations like the financial market. The state and financial institutions cannot regulate, or extend their rules and requirements to the cryptocurrency market. In the absence of centralized control, traders are less protected and more likely to suffer huge losses. This means that crypto traders can only rely on market analysis, strategies and experience.

How to Use Hedging to Minimize Trading Risks?

Hedging is aimed at minimizing risks. But how to use it in the cryptocurrency market? How to hedge bitcoin with no risk? To understand this, we first describe the preconditions. A trader has a fairly successful profit from a certain cryptocurrency, for example, Ethereum. Studying the market, staying up to date with all the news, or intuitively, the trader understands that there is a possibility of an imminent decline in price. The correct strategy would be to hedge the asset. This means that he needs to acquire a profitable and stable cryptocurrency at the moment and shortly. Thus, he will be able to protect and compensate for the loss. The first asset, when the market fluctuates, can bring a loss, while the second asset will bring a positive profit, covering the losses from the first asset.

Types of Cryptocurrency Risks

Let’s highlight the main risks when trading cryptocurrency.

Cryptocurrencies are Volatile

Cryptocurrencies are notoriously volatile, and this volatility can be amplified when you use leverage. This means that even small market movements can have a big impact on your position, and this can be either positive or negative. Traders buy cryptocurrencies because they are growing in price. And they grow in price – precisely because investors buy them, and this is a kind of vicious circle on which you can both earn and lose. In this case, just market analysis and strategies such as hedging help to stay out of the red.

They are Unregulated

As we mentioned earlier, cryptocurrencies are not regulated by law or by any central authority. This is inconvenient for government agencies, in the context of taxes and regulation. Cryptocurrency, which was created as a spontaneous and regulation-free alternative to national currencies, has become the subject of close attention of regulators around the world. That is why in the future there may be big changes on the part of individual states. The rules of use for cryptocurrencies are still being created and differ from country to country. If the growth of this sector continues, it could quickly reach the point where it becomes a threat to global financial stability.

Transactional Risks

The need to transfer cryptocurrency sooner or later arises for almost every user. But both investors and active traders have the risk of losing funds. There can be many reasons – for example, an error when copying the address or a tag that was not specified due to forgetfulness. When sending cryptocurrency, you need to check many data. If you miss something, you will have to say goodbye to the money. You can also end up on phishing sites. If you indicate your data on it or transfer funds to the wallet indicated there, they will be lost.

Leverage Risks

Leverage can be a powerful tool, but it also comes with risks. When you trade with leverage, you’re essentially borrowing money from the broker to trade more than you could with your capital. This can help you make bigger profits – but it can also magnify your losses if the market moves against you.

Susceptibility to Hacking

Such a risk seems unrealistic to many with today’s security systems. However, there are known cases of hacking crypto platforms and wallets with the theft of all user funds. In case of bankruptcy of the sites, all its participants lose money. At the same time, the crypto exchange does not have to be completely closed. For example, you can significantly increase the rates for withdrawing funds. Or to manipulate the rates of cryptocurrencies, overestimating or underestimating the rates in a favorable direction.

Reliance on Technology

The crypto industry is highly reliant on technology. From the development of blockchain technology to the maintenance of digital wallets, everything in the space requires a deep understanding of how technology works. This reliance can be both good and bad. On the one hand, it allows the crypto industry to innovate and create new opportunities at a rapid pace. On the other hand, it also makes the industry very vulnerable to disruptions in the event of a technical glitch or hack.

Let’s talk about hedging cryptocurrency methods and tell you how to use them.

Portfolio Diversification

Diversification is one of several risk management strategies in portfolio investing. It involves a variety of assets to distribute risk. The greater the variety of assets, the lower the risks. When investing all the money in one asset, the portfolio becomes highly dependent on the course dynamics. These are huge risks because if the price of the cryptocurrency collapses, your portfolio will fall sharply in price. If you follow a diversification strategy, then in the event of a collapse, some positions will bring losses, while others will make a profit.

Short-Selling Assets to Hedge Crypto

One popular way of cryptocurrency hedging is to short-sell assets. In other words, you would bet against the price of a cryptocurrency by selling it, hoping that the price will fall so you can buy it back at a lower price and profit from the difference. Of course, this strategy is not without riskю If the price of the asset you are shorting goes up instead of down, you will incur losses. That being said, short-selling can be an effective way to hedge cryptocurrency against downside risk.

Futures for Crypto Hedging

Traders can also use derivatives to hedge cryptocurrencies. One of the most common methods is futures. It is a type of financial contract between parties who have agreed to trade a certain crypto asset at a predetermined price on a certain date in the future. Thus, the risk of falling prices is reduced if you take a short futures position. And to make a profit already when the price rises by opening a long futures position.

Perpetual Swaps

Perpetual swaps are one derivative with which you can sell or buy the underlying asset without setting an expiration date on the position. That is, a trader can enter or exit a position at any time. Perpetual swaps have several advantages of cryptocurrency hedging. Firstly, it is high liquidity that attracts most traders. Due to the high level of hedging, it turns out to earn more by investing less.

Options

There are two types of options: puts and calls. The first one means the right to sell a cryptocurrency at a specified price within a specified period, while the second one provides the right to buy a cryptocurrency at a specified price within a specified period. Options are often used for hedging. For instance, if a trade has a cryptocurrency in its portfolio that will fall in value, he/she can put options to hedge the position. Alternatively, if you one thinking about a sudden price increase, he/she can buy call options at a fixed price.

How To Hedge Cryptocurrency Correctly?

There are some basic steps before applying hedging strategies. The first is smart trading on the cryptocurrency exchange. You can try on small and reliable assets, try hedging bitcoin. The second is to learn how to read and analyze price rise and fall charts. The third is to start crypto hedging with smaller steps and then move on to more significant amounts.

The most important thing in understanding how to hedge crypto is that a trader should know the need to take a position opposite to the current one. Let us explain that if an asset’s price falls predictably, it is worth opening a short position, and if the price rises, then a long one.

Is Hedging 100% Risk-Free?

Hedging is often viewed as a risk-free way to protect an investment, but this is not always the case. While hedging can help reduce downside risk, it can also create new risks. The most important thing is to understand that there is no 100% guarantee that the second asset you have chosen will not fall sharply in price even if you analyze all the charts and rely on signals.

The Bottom Line

Hedging is one of the most popular strategies that traders use to reduce the risk of trading in the cryptocurrency market. When applying basic hedging strategies, a trader needs to understand that both positive and negative results can follow them. However, the main thing remains that with the correct and effective use of this risk management strategy, you can protect your portfolio from severe losses.

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• Source: Plato Data Intelligence: Platodata.ai