Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price.
The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this can be impossible. Therefore, individuals attempt to neutralize risk as much as possible instead.
There 4 different methods to hedge out your cryptocurrency exposure.
#1 — Short Selling
The most straightforward method is to short sell the crypto that your are looking to hedge so that you end up with something like this (assuming you want to fully hedge):
Why You Would Use This
Generally you are better off just selling your cryptos because the cost of short selling is higher:
- Cost of Selling = Transaction Fee
- Cost of Short Selling = Transaction Fee + Margin Funding Cost
However if you are someone that is concerned about having your money in crypto exchanges but still want to hedge for a short period then this is better because:
- Once you sell your cryptos on the exchange, the proceeds of the sale remains on the crypto exchange until you withdraw it (which isn’t always that easy) which makes it subject to default risk.
- In comparison short selling only requires you to have a smaller amount of your crypto/money on the exchange so the risk is a lot more limited.
- Lastly as mentioned if your hedge period is short then to sell, withdraw only to deposit and buyback could be too slow and cumbersome.
#2 — Futures
Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset, such as a physical commodity or a financial instrument, at a predetermined future date and price.
Just like in traditional finance there are futures in cryptocurrencies which you can use to hedge out your position.
Why You Would Use This
Futures is a fairly cost efficient way to hedge out your risk. This is because:
- You can be highly leveraged meaning you have a lower capital requirement (though you would have to make sure to meet your margin requirements to avoid margin calls).
- Depending on market conditions, you can even profit from the hedge over time.
- You know the cost of your hedge the moment you place the hedge on.
- Hedge cost = Transaction Fee + Premium/Discount of Futures Contract
In addition the benefits of using inverse futures for hedging crypto are:
- Don’t need USD so you can keep you crypto holdings without converting them. This makes it easier for rebalancing as well.
- The margin requirements are less strict for inverse futures because they are not on CBOE or CME, whom are highly regulated futures exchanges.
- There are more cryptocurrency choices to choose from compared to standard USD futures e.g. there are ETH, BCH, XRP.
- Can get more granular contract sizes as inverse future on Bitmex is 1 USD contracts whereas CBOE minimum size is 1BTC and CME is 5BTC contracts
The main downside to using inverse futures is that this is that using an exchange like Bitmex has a higher exchange default risk due to the fact that it is not as highly regulated as CBOE or CME.
Please refer to this for some basic information on the mechanics of futures. It is recommended to research more on futures if that is what you intend to use and read the fine print in each of the futures contracts you use.
Deviation In Price Of Underlying
Futures contract all state the method in which it is priced upon and there could be instances where it deviates from the general market price of the crypto (just like I explained in short selling).
For example CBOE BTC futures is priced upon the BTC price on Gemini exchange (underlying) at its time of expiration. This means that if you don’t use Gemini and for some reason the exchange you use has a price deviation from Gemini’s BTC pricing, this could mean that the profit and loss of the futures contract you use for hedging may also deviate from your actual profit and loss (can be good or bad for you depending on deviation).
#3 — Perpetual Swaps
Perpetual swaps (perpetuals) have recently grown in popularity as more and more crypto exchanges have started to offer them. Their use is very similar to that of inverse futures with the main differences being:
- A periodic funding rate (usually 8 hours)
- No expiration date
To understand the perpetuals you can check this link here which is the guide by Bitmex, the first crypto exchange to have perpetuals. Some of the concepts such as calculating the funding rate can get complicated however to use swaps only a high level understanding is needed as the systems will calculate funding rate for you.
Why You Would Use This
The key reasons to use this are the same as futures with the main difference being that the short funding rate means that the perpetual swaps track the underlying prices closer than the future for most cases. However this also means that your actual hedging cost can vary (since funding rates are re-adjusted every 8 hours).
Also not having to deal with rollovers means you incur less trading costs.
#4 — Options
Options in cryptocurrency space are still a fairly new and limited. The only exchanges that offer it are currently Deribit and Bitmex. However they have been around in the financial markets for ages and often used for hedging purposes.
Hedging with options can be pretty complicated and there are multiple ways you can build the payoff you want. However below is one of the most straightforward ways to hedge out your downside risk that I know of. It is not the cheapest hedging method, as there could be a version of it where you sell call options etc. to bring down trading costs (in exchange for upside potential), but this method is the easiest to implement. It also gets you started on using options for hedging.
Why You Would Use This
One of the main benefits to using options in this way to hedge out risk is the difference in payout. Buying put options to hedge can effectively turn your existing options into a call option payout (limited downside with unlimited upside). The caveat of this is that options, especially in cryptocurrency space, are fairly expensive so you would be paying a significant amount to have this optionality/payout structure.
In addition margin does not need to be monitored because we are purchasing options to construct this hedge. Thus this makes it a fairly good choice for investors that are:
- Looking to hedge but cannot or do not want to have to deal with monitoring their margin requirements
- Want downside protection but maintaining the potential upside gains and do not mind paying more for this.
Most investors in cryptocurrency probably want the exposure as they expect it to “go to the moon”. But in some cases they might not want to because they are
Miners need to pay their electricity and other costs in USD so they may wish to have more predictability on their returns. They could sell their crypto directly whenever they successfully mine new coins, however it may be more beneficial for them to group up their cryptos and sell in one larger batch periodically to negotiate better fees and reduce certain transfer costs.
An ICO Project
ICO projects often incur costs in USD and have a need for a more predictable cash flow. However they do not want to be seen selling out their own tokens or crypto, as it could be a negative sign to investors/token holders. Hence they could opt to hedge out some of the risk to ensure a more predictable cash flow down the road when they opt to sell the cryptos that they hold.
Certain funds may employ a strategy that is based on a return relative to bitcoin. In this case they would overlay their portfolio with a BTC equivalent hedge so that the returns they get are relative to BTC’s performance.