When an individual begins to dive into investing, it is necessary to know that the assets purchased will have price fluctuations.
It means that the value of the purchased asset will not only increase but can also move down and provide potential losses.
The good news is that there is one strategy to mitigate the risk of such losses in the investment world and financial markets as a whole.
This strategy is called hedging, often used by institutional investors, but retail investors are starting to do it too.
What is Crypto Hedging?
In finance, the term means protecting the value of wealth through mitigating the volatility of the price of an asset.
Retail investors generally carry out this strategy with considerable experience in the financial markets.
Most users of this strategy are institutional investors with significant enough managed funds when they enter the world of finance.
In summary, hedging means diversifying or allocating money to several different assets.
Generally, asset allocation is divided between assets that are risky or have high price fluctuations and safety assets or those that have low price fluctuations.
There is another way of allocation: investors or traders allocate their money to assets predicted to go down and up.
The goal is to keep his wealth from diminishing and safe without having to pay storage fees like, for example, in a bank.
An example of an analogy most often used when describing hedging is the same as buying insurance against a home.
After buying a house, especially in an area prone to disasters, a homeowner will purchase insurance.
The goal is that when something unexpected happens, the loss can be replaced by insurance.
Just like this, an investor who buys an asset will buy another purchase so that if the first asset loses, the loss can be covered by the profits of the other asset.
How to Hedging in the Crypto Market
Asset Diversification
As previously mentioned, hedging is to diversify or allocate investors’ money to several assets.
The goal is that if one asset moves at a loss, the loss can be covered by the gains from another investment.
The most common way of diversification is to buy multiple assets, for example, purchasing multiple crypto assets or buying both crypto assets and mutual funds simultaneously.
But this method is generally done by retail investors. Institutional investors or traders typically have other strategies to maintain their wealth.
Take advantage of the Spot and Derivatives
One of the most common strategies is taking advantage of the spot and derivatives markets, such as futures and options.
Before exploring how to hedge with derivative assets, investors should understand how derivative contracts work.
In the derivatives market, a transaction is a contract of ownership of an asset. So the transactions that occur are not the original asset transactions like in the spot market.
Investors should also be aware that trading derivatives contracts have the option of making a sale without owning the asset first.
The transaction has a short name if it uses the futures or a put if it uses the options market.
With this option, investors can make profits when prices move down. Next, this article will discuss hedging examples using examples of Bitcoin assets, perpetual Bitcoin futures contracts, and quarters.
Examples of Hedging
Here are two examples of an investor wanting to hedge with different results.
Hedging Without Seeking Profit
The first is a way of hedging if you want to keep wealth without looking for profit.
For example, an investor has $33.682 in cash and wants to maintain his wealth by buying Bitcoin on the spot.
He started believing in January 2021 because he wanted to experience what it’s like to be a Bitcoin investor.
Because he wanted to be safe, the investor bought Bitcoin for only $16.843 in January 2021.
With the remaining money, he hedged with a short order in a perpetual $16.843.
He does this to ensure that his perpetual futures contract will cover the loss if Bitcoin goes down.
The reason is that perpetual futures contracts move at relatively the same price as their assets in the spot market.
So, for example, from January 2021 to December 2021, Bitcoin fell by about 40%, and he would lose 40% of $16.843.
But because the investor also opened a short position of $16.843, he received a 40% profit from his perpetual futures contract.
Finally, at the end of December, he still had $33.682 due to the movement of two opposite assets.
Hedging for Profit
Another example is if investors want to secure wealth but still want a little profit.
This method is riskier because something that provides potential profits will also offer potential losses.
If you do this, the method is the same as before. However, the assets used are traditional futures contracts such as Bitcoin quarterly, which expire every three months.
Investors will buy Bitcoin in January 2021 for $16.843.
For hedging and seeking profit potential, he also opens short positions.
The short position to be carried out is on quarterly futures contracts with an expiry in December 2021 of $16.843.
Profits will later be obtained because there is a difference between this traditional quarterly Bitcoin futures contract and the price of the Bitcoin asset.
Generally, if this contract goes down, its value will decrease by more than the original asset. Conversely, when the spot asset price increases, this contract will go higher.
For example, Bitcoin is down about 20%, but the futures contract is down about 25%.
So because you have opened a short position, the investor will profit 5%, where 20% loss will be covered by 25% profit.
Finally, investors who buy Bitcoin and open short positions are left with a 5% net profit of $33.682.
This strategy can be done if you are sure that the price of the purchased asset will go down in a particular quarter.
This belief can be obtained through in-depth analysis. So the science of research needs to be obtained first.
This strategy mechanism is often used by institutions that want to maintain wealth.
The wealth in question can come from company and investor funds that become consumers of the institution’s services.
The conclusion is that this strategy requires a deep understanding of the financial and investment markets.
So before applying, it’s a good idea for investors to explore how to analyze and hedge, especially in the crypto market.
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