Hedging is a strategy used by all sorts of market participants. It is widely used in commodity trading, hedge fund, and portfolio management strategies. And you can use it for crypto trading.
Hedging is an instrument for protecting capital gains and avoiding losses. You can think of it like a synthetic insurance policy.
For many, the use of hedging is perhaps too advanced.
On the other hand, as your trading skills expand along with your account holdings, this can be a valuable tool.
And you don’t have to be a hedge fund to take advantage of simple hedging strategies.
But, before we continue, the obligatory disclaimer. What follows is, as always, not trading or investing advice. This is for information purposes and should act as a catalyst for further investigation.
Now that we have that out of the way let’s talk about what hedging is.
What is hedging?
Hedging is a risk management technique that can be used in a variety of trading contexts.
Investopedia defines hedging as “an investment that is made with the intention of reducing risks of adverse price movements in an asset.” In Webster’s Dictionary, hedging means “to protect oneself from losing or failing by a counterbalancing action.”
It is used extensively by commodity producers and consumers to lock in prices for products to be delivered at some point in the future.
Options pros or market makers use hedging to offset the call and put options they sell.
Equity traders use option-based hedges to protect up and downside of respective positions. They can also use a replacement strategy for existing positions as a sort of hedge.
Large portfolio managers may use a variety of instruments, including index futures, and government securities to protect portfolio downside.
While bitcoin is sometimes described as a hedge, there are various instances where bitcoin exposure itself could benefit from hedging.
The origin of hedging as an idea is old, some say dating back to the 1400s. However, for most, the term is often associated with the hedge fund.
The sociologist that started the first hedge fund
The principle behind the hedge fund concept was flexibility. Unencumbered by restrictive covenants and fund rules, hedge funds have a broad spectrum of trading and investment options.
The origin of the hedge fund is attributed to a sociologist. He came up with the idea while working on an article about technical analysis for Fortune Magazine in the 1940s. Alfred Winslow Jones, founder of the modern hedge fund, described hedging as “a speculative activity to achieve conservative ends.”
The speculative part he used was short selling combined with some leverage. The conservative part was protecting the downside for a portion of the portfolio.
The advantage of the hedge fund model was that when the market went up, they participated in the upside. But when it went down, it either didn’t go down much or in the case of some strategies, actually made spectacular gains.
The Jones hedge fund approach started in 1949, and the model expanded to others in the late 60s and early 70s.
This is where the legends of George Soros, Stan Druckenmiller, Michael Steinhardt, Ray Dalio, Paul Tudor Jones, and many others began. Even Warren Buffet was a hedgie during the 60s in his pre-Berkshire days, according to James Altucher in his book Trade Like Warren Buffet. More recently, quants like Jim Simons of Renaissance have become famous hedge fund names.
Hedge funds were once a small club of swashbucklers. However, their ranks have exploded in the last two decades making the market incredibly competitive.
The evolving and maturing crypto market
We’ve previously discussed how price discovery has continued to mature in bitcoin and ether. Yes, there is volatility, but clearing prices are quickly identified where liquidity is available to be exploited. And arbitrage across liquidity pools and geographies creates more reliable pricing across the world.
A part of that price discovery mechanism involves the ability to use various products for hedging. These include both cash and “physical” delivered futures, ETFs, options, equities, and other products.
Pricing is shaped by all of the products and services that use a given crypto asset. For example, all of the exchanges and trading platforms around the world show us what the clearing or spot price for various listed crypto, altcoins, and tokens are.
The greater the popularity and durability of the crypto project, the more likely it will have derivatives available for hedging.
The speculative nature of the crypto combined with leverage has resulted in wild swings in the overall crypto market cap between one and three trillion. These gigantic swings have created plentiful trading opportunities.
So, can a crypto trader running his or her own coins use Alfred Winslow Jones’ idea of hedging to their advantage?
You can, and there are a variety of instruments one can use for this activity.
Crypto hedging starts with some thinking
Now, if we get back to trading in speculative markets, the one thing that becomes clear is that risk management is important. And that means emphasizing return of capital.
You have to read those white papers and keep an eye on the leaders if they are on social media. Watch what they say and criticisms of the platform or protocol.
The first hedge against problems is awareness and preparation.
One problem you will face is that having positions in certain coins doesn’t give you the luxury of futures and options. Although in time, many of the big projects will have these types of products.
For the most part, BTC and ETH have the most liquidity and the most products available for hedging.
That means options, futures, some listed equities, and other products.
Plus, speaking of hedging, control of your keys should be a major consideration here as well. The market may go down, but when you give your keys to a company, and they go down, the loss can be much worse. So the ability to act as your own bank through personal custody could also be considered a form of hedging.
Hedging products for bitcoin and ether
For ETH and BTC, one has a variety of ways to hedge.
One way to hedge is with options.
You can buy put options to protect yourself from downside. This means taking on an additional position with a different product without selling the one you already have.
Or you can sell your position and replace it with a call option instead. The call can be used as an asset replacement position where you can retain exposure for a fee. Your downside will be the premium you pay for the option. But if BTC or ETH goes higher while you own the option, you continue to participate until expiry.
As we discussed in our options piece, it’s important to understand the contract specs of these products in advance. The specs would include the expiry, delivery requirements (cash or crypto), when you can exercise the contract (American or European style options), and any other specifics.
The same applies to futures. BTC and ETH futures and mini contracts provide a range of ways to use futures for hedging. These include shorting futures or using options on futures. Again the contract specs are critical to understand before getting involved.
You might also look for listed equities as proxies for various instruments and easier ways for short exposure. Again, not saying you should do this, but it’s just another way to use an instrument for hedging specific exposure. For example, MicroStrategy could be a good proxy for Bitcoin, given its significant stake. Or you could look at other listed crypto entities like Coinbase.
…but hedging isn’t free
Hedging isn’t a costless activity. A great example of this is when Taleb criticized the fund manager of Calpers, California’s pension fund, for the way it hedged tail risk.
Now, remember that Taleb is the advisor to Universa, run by Mark Spitznagel. Their fund is designed to be a cost-effective tail risk hedging strategy that positions you for outsized chaos.
The Calpers fund manager was taking credit for hedging downside during a market rout and touting the outcomes. Taleb challenged that notion, indicating that the fund manager “spent” too much on the supposed benefit, given the protection he claimed to have provided.
Which is to say that hedging has a variety of costs associated with it.
So what are the costs?
There are opportunity costs. If you protect the downside of your position and it goes higher, you give some of that up. This is a form of opportunity cost.
The premium you pay for an option contract is a cost. There is the potential for slippage. And when you use sophisticated options trading strategies, there are other risks.
If you are using futures, there are margin, execution, and opportunity costs.
So any time you are thinking about hedging, it’s not just the protection, but the cost of that protection in terms of opportunity cost, slippage and other tangible costs.
For crypto, there is comfort with leverage but not so much with hedging
Crypto volatility is a normal feature of a speculative instrument. And it is remarkable that even though crypto is speculative, there are various hedging options available to assist with parts of the market.
And it is likely that as businesses adopt more crypto offerings, crypto asset management will become more important. Meaning that these exposures will have to be managed with hedging strategies from time to time.
For the individual, hedging requires you to think out the scenarios you may face and have a plan. And that means risk management and a reasonably clear understanding of the market and conditions.
Hedging is simply a short-term synthetic insurance policy against adverse moves in your positions. Adverse moves can apply to both the long and short side.
Hedging is something you should be aware of even if you aren’t an active trader or your account hasn’t realized a significant size yet.
But actively exploring hedging might make sense for the growing trader with significant assets.
In the meantime, keep an eye on that risk pendulum so that you’re ready to go when it reaches the extreme.
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