Hedging risks on the cryptocurrency market: 3 effective ways
The cryptocurrency market provides many opportunities for traders to make money. At the same time, it is worth remembering that cryptocurrencies have a very high volatility and instability, which increases trading risks many times over. Every competent trader knows that it is better to miss a profit than to incur a loss.
How to properly minimize risks when trading cryptocurrencies? This is where the three most common ways of hedging in the cryptocurrency market come to the trader's aid.
Method #1: Diversify your cryptocurrency portfolio
There is a saying that urges you not to put all your eggs in one basket. In essence, this is diversification in simple terms. That is, you should not invest all of your capital in one or more similar assets.
Diversification is considered the easiest way to hedge risks and has long been used in the stock and currency markets, but the cryptocurrency market is more homogeneous than the stock market, which imposes its own characteristics on its application.
When diversifying your digital asset portfolio, you should always remember that almost all cryptocurrencies, with few exceptions, tend to move in one direction. Therefore, to compensate for the risks when trading altcoins, it is quite reasonable to include the top cryptocurrencies in your portfolio.
Do not count on the fact that you will be able to find the combination you need on the first try. It is quite possible that some attempts will not bring success, but sooner or later, experiments to find a successful combination for diversification.
Method #2: Hedging with Short Selling
The hedging strategy using short selling is more advanced. Its goal is to insure the trader against a sharp decline in the cryptocurrency rate at a time when it was expected to grow.
The essence of this method is to sell an asset obtained from the exchange through margin trading. In simple words, the trader sells to open a position and then redeems it after the price of the asset decreases, making a profit due to the difference in rates. To increase the effect of the strategy, leverage is used up to its maximum possible value.
Example
Let's explain in more detail with an example. Suppose the trader has a certain amount of bitcoins, which he is holding, hoping for the growth of its rate. To insure yourself against BTC price decreaseThe trader opens a margin deal, borrowing 1 bitcoin from the exchange, and immediately sells it.
After selling 1 BTC at $8000 and waiting for the rate to fall to $7,500, the trader redeems it, thus repaying the margin credit and getting $500 as compensation for the loss from holding the bitcoins.
The complexity of this method is that it carries a certain amount of additional costs - transaction fees, interest margin, etc. Therefore, for its competent use it is necessary to calculate in advance the balance between the hedging position and the held volume.
Method #3. Using derivatives
Derivatives are derivative financial instruments such as futures, options, forward contracts, swaps, etc. These instruments are widely used in traditional markets.
Derivatives in the cryptocurrency market are still in their infancy and development. Nevertheless, some crypto exchanges offer traders the opportunity to trade futures and swaps.
Example
For example, a trader expects bitcoin to fall from the current $8,000 to $6,000 in two weeks. He sells a bitcoin futures at the current price. Let's assume that the forecast is correct and the bitcoin price falls to $6,000 in two weeks. At the time the futures contract is executed, the trader will receive $2,000, offsetting his losses on the underlying asset.
Conclusion
First of all, the trader must clearly understand that the main purpose of hedging strategies - is not to make a profit, and a way to protect against high trade risks. By hedging your risks, you will not make a significant profit, but you can ensure the stability of your trading.
Remember, good traders see the opportunities and the best traders understand the trading risks.
Read about profitable investments in the foreign exchange market in our book. Download for free