Hedging methods give you the opportunity to reduce your risks in times when you think that crypto prices will fall while keeping your coins, or at least staying within the segment, while also avoiding taxing in a certain period. That doesn’t mean that you won’t pay taxes on your profits, rather that you will be able to tweak the timing of the taxation, and maybe optimize the payable amount as well.
Also, in a lot of cases, it is easier and cheaper to enter a hedging position than straight up selling your coins. Sure enough, these positions have their own negatives cost- or otherwise. Trading fees, spreads, counterparty risk, cash losses, and particular tax issues could make them less alluring, while given the less developed state of the segment, availability is also an issue.
Traditional Vs Crypto-Hedging
In the case of liquid traditional assets (stocks, commodities, bonds, currencies), there is a wide range of assets and methods to choose from for hedging purposes, such as options, futures, futures options, forex options, ETFs, swaps…
While several of those now have the equivalent in the crypto-space, the real-world usage of the crypto versions is often far from the traditional ones, and their application requires much more effort and sometimes a leap of faith.
That said, the future is bright for those who want more flexibility in managing their exposure and the excessive volatility in the segment, as the number of available hedging assets is rising by the day – and that doesn’t just mean the widely covered BTC futures contracts or the LedgerX platform. But how does hedging work anyway?
Let’s dive into the basics.
The Basics of Hedging
The basic concept of hedging is that you purchase an asset that’s value is moving in the opposite direction than the one you want to protect. Traditionally, the producers of commodities used futures contracts to “lock-in” the price of their product for a certain future point in time.
Today, with all the hedging options available, the concept can be used for all kinds of time-periods, asset classes, and different levels of protection. Also, the assets once only used for hedging purposes are widely used “naked” – purely for speculative reasons, often taking advantage of the leverage applied through some of the products.
Leverage and Hedging
While not all hedging products use leverage, it is a natural and useful part of hedging as it gives a traditional hedger the opportunity to protect a large amount of exposure with a much smaller amount of cash. Imagine that with 5-10% of your protected amount, you can be sure that you will able to sell (or buy) your entire holding for the desired price.
That advantage could turn into a deadly weapon in the hands of a rookie speculator, who uses leverage (margin trading) to increase his profits or losses with no “products” or other assets to cover, the sometimes large, fluctuations in the value of the hedging asset.
Hedging and Cryptocurrencies
When it comes to cryptocurrencies, leverage is only loosely connected to the concept of hedging, and a lot of traders and investors are playing the markets with way larger positions than their invested capital.
That said, leveraged hedging products are already available, and they offer one of the best ways to protect your profits without selling your precious coins, and even giving you the flexibility to take additional positions in other coins that you think have a better risk profile.
Basically, for a small fee, you can get rid of the risk of holding your coins (for a while) without actually losing them.
Of course, not everything is rosy, as if you have all your capital in coins, with no significant cash holdings for example, you might have a hard time managing your positions. I will look into those and other problems in the second part of the article.
Hedging Strategies and Hedging Assets
Some accomplished investors say that the only hedging you need is diversification, and spending on hedging assets is a waste of time. That might be true for a lot of value-focused conservative investors, others might find significant value in the different methods listed below (and detailed in my coming article).
Also, although leveraged trading can be very dangerous, some of the leveraged strategies and assets (options, pair trading) offer ways to limit risks and trade more consciously.
In a broad sense the hedging strategies that I will cover can mean:
- Holding a certain mix of coins, cash (fiat), and leveraged crypto positions
- Holding special (derivative) assets such as futures or options contracts
For starters, what this means, is that you might need more than one account to access the desired products, which is a clear disadvantage compared to a non-crypto portfolio, but at the end of the day, the benefits might be worth the efforts.
Looking ahead to the exact methods we will discuss the following:
- Derivatives: futures contracts, options contracts
- Correlation-based hedging: safe-haven pairs, “Pair” trade hedging
- Diversification
- Tether USD and fiat holdings
While some of those might sound complicated, we will provide a step-by-step guide to understand and use the strategies. Stay tuned.
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