What is hedging in crypto: the risk management strategy for reducing crypto risk

Hedging is a risk management strategy crypto traders adopt to reduce their exposure to risk and potentially minimize losses. Hedging is commonplace among stock traders, and it’s an especially important concept to understand and adopt when trading the volatile crypto markets.

In this essential guide, we’ll explain what hedging in crypto is in more detail, explore how to use hedging with examples, and detail the risks and benefits of crypto hedging.

TL;DR

• Hedging is a form of risk management traders use to limit their losses should the market move against their expectations.

• Hedging is used by traders of all financial vehicles, and is particularly helpful for crypto traders because the market is especially volatile.

• You can hedge with a simple spot position or adopt a more complex position, such as options or futures.

• Although hedging in crypto can reduce losses, it does bring downsides, such as limited potential gains, higher costs, and added complexity.

• Traders of all experience levels would be wise to consider hedging as part of their crypto trading strategy, especially during periods of high volatility.

What is hedging?

Hedging is a risk management tactic that involves opening a trading position or positions. When hedging, a trader will open a position that directly opposes another open trade. The goal of the hedge is to capture gains should the original position move against the trader, minimizing the total loss. Hedging is particularly useful when trading the crypto markets because of the high volatility faced.

How does hedging work?

By now, we know that hedging involves opening two opposing positions for a related asset. However, this doesn't need to be the same asset, but should involve assets that are correlated. Because of this correlation, when the price of one asset moves, it's theoretically easier to predict the movement of the other asset, allowing the hedge to be effective.

By hedging, traders strategically open positions to reduce their exposure to risk should prices move against their expectations. As a result, hedging both minimizes risk and potentially reduces gains, as one side of the hedge is expected to lose.

What's an example of hedging?

Hedging with correlated assets

During a period of sideways price action, you complete your technical analysis and decide to buy $3,000 of Bitcoin (BTC) while the asset is valued at $80,000, expecting prices to rise. However, given the uncertainty in the market, you decide to hedge the position.

To do so, you also open a short position on Ethereum worth $3,000 — the same value as your long BTC position. You choose to short Ether because you know that when BTC prices fall, ETH prices often follow, due to their correlation. As a result, if Bitcoin were to fall in value and you face a loss, your Ether position should make a gain, if the correlation is proven correct.

This hedging approach is well suited to beginner traders because the short Ether trade can be a spot position, which is relatively simple to set up and execute.

Hedging with the same asset

Let's look at another example of hedging, but with the same asset. We'll use the hypothetical situation of wanting to buy $3,000 of Bitcoin (open a long position) at a value of $80,000 per BTC. Once again, you expect prices to rise.

To hedge and open an opposite BTC position, you sell (short) Bitcoin with a long put option contract. With this position, you're covered if BTC were to fall in value, as the put option gives you the right (but not the obligation) to sell Bitcoin at the strike price you set in advance. As a result, you're offsetting the losses faced by your original long position.

Why use a put option contract to hedge and not a spot position? Although a spot position would also work in this situation, using a put option contract gives you greater control over the price you close the position at if prices move against you. Capital efficiency wise, you'll also be dedicating less than the margin you'd require if you're hedging with a short spot trade.

Keep in mind that this form of hedging is better suited to more experienced traders who are confident in applying options trading, which is more complicated than spot trading.

Risks and benefits of hedging

Being a risk management tactic, there are pros and cons of hedging you need to be aware of before applying it to your trading strategy.

Risks of hedging

• Additional costs: Hedging brings with it additional costs that can eat into your overall gains. One cost to be aware of is the premium when buying an options contract. The premium is a price paid to the seller for the rights outlined in the contract. Another cost comes from the additional position you'll open as the hedge. Assuming your primary position performs as expected, the hedge becomes a losing position, costing you its value.

• Limited potential gains: Hedging can limit your potential gains because it involves opening an opposing position, which comes at a cost. Although that might be painful, think of it as insurance to protect you from potentially larger losses.

• Added complexity: Hedging can add another layer of complexity to your trading strategy that could impact your overall success, as time is spent creating the hedge rather than the primary position. This is particularly true if you choose more complicated forms of trading for the hedge, such as options and futures. Extra complexity could affect your decision-making, leading you to be overly cautious or to overtrade, which could bring greater losses.

• Market timing: Hedging requires you to time the market twice — once for your primary position, and once for your hedge. A poorly timed hedge could lead to larger losses for both your primary and hedge position.

Benefits of hedging

• Reduced risk: Reducing risk is the main motivation for using a hedge when trading cryptocurrencies. This benefit is amplified during periods of high volatility, when price swings can be extreme.

• Preserving gains: Although hedging can bring additional costs, it’s ultimately designed to reduce losses and therefore preserve your overall gains.

• Flexibility: Hedging with an options strategy allows for added flexibility, as you gain downside protection along with upside participation. Meanwhile, with covered calls, you can sell a call option and make gains while protecting your primary position.

• Psychological edge: For some crypto traders, hedging is as much a psychological benefit as it is a tangible one. Knowing you have a hedge in place to offset losses can bring added confidence, allowing you to execute your trading strategy with maximum effectiveness.

The final word

Hedging is a common tactic traders use to manage risk, particularly crypto traders who must grapple with inherent volatility from the market. Hedging can be a relatively simple process, involving an opposing spot trade to offset losses and preserve some gains. Meanwhile, by instead adopting more complex approaches such as options and futures, traders can gain greater control over closing prices. Ultimately, it's important to choose the hedging method you're confident with, so you're best placed to reduce risk and protect your gains.

Interested in learning more about crypto risk management? Read our guides to diversification and the take profit and stop-loss tools.