4 Ways to Hedge Out Your Cryptocurrency Exposure

Cham Ho
Good Audience
Published in
15 min readNov 8, 2018

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Looking for ways to hedge out your cryptocurrency exposure?

Perfect. As I cover 4 different methods to hedge out your cryptocurrency exposure with a brief section at the end of “why people hedge” to show some of the use cases for this type of strategy.

As I am a fan of TL DR summaries I have created a summary ranking table below (based on my opinion) for you to reference (though I would highly recommend reading the sections you are interested in):

Selling vs Hedging

Guess the first questions people would ask is why do we need to hedge when we can just sell? This is a good point and the answer can vary depending on what hedge you go for (which I’ll cover in each section) but at a high level comparison:

#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):

All cryptocurrency references below are used only as an example.

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.

Also compared to other hedging methods:

  • This is suitable for a wider range of cryptos e.g. you can do it on tokens such as ZRX as well.

How To Construct This

What you need:

  • An account with an exchange that can short sell e.g. Bitfinex, Kraken
  • (Optional) USD for maintaining margin in your account

Steps to construct this (using BTC as an example):

  1. Deposit in your USD into the exchange that can short sell (if you do not have any USD then you will need to deposit in your crypto and sell some of it).
  2. Note the amount of USD you should deposit will depend upon the margin requirement of the exchange you use and also your tolerance for risk.
  3. Put on a short position into the cryptocurrency that you want to hedge for at 1:1 ratio. For example if you hold 10 BTC and you want to hedge it, short 10 BTC equivalent.
  4. Monitor your short positions profit and loss so that if you are getting close to your margin call, you will need to deposit more USD or cryptocurrency into the exchange to maintain your short position.
  5. Note depositing into the exchanges can take time and since crypto markets can be very volatile, best to not cut it to close before topping up.
  6. Close out your short positions whenever you wish to close out your hedge.

Summary

Short selling as hedge is best suited for investors carrying a diverse range of cryptos that want to hedge but do not want to sell out their cryptos or have to liquidate their portfolio.

Pros and Cons for using short selling for hedging:

Risks

The “risk” to short selling is when there is a deviation in the price you shorted at versus your actual crypto portfolios movement. Below is the more common ones I can think of:

Deviation In Price Of Exchange Used

The exchange you short on may have a different price to the exchange you are actually using to trade your crypto. For example if you normally use Gemini and your short was on Bitfinex then if for some reason Bitfinex prices don’t go down when Gemini prices go down then your hedge will be ineffective.

This can happen for a variety of reasons but the more common ones could be:

  • Exchange default risk
  • Airdrops
  • Forks

These type of events could result in a deviation between the general market price of your crypto and the exchange you shorted on.

#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.” — from Investopedia.

Just like in traditional finance there are futures in cryptocurrencies which you can use to hedge out your position. I won’t be explaining the mechanics of futures too much here but you can refer to this article for a bit more information. Generally the crypto market comes with one of two types of futures:

Futures that trade in USD pricing and settle in USD

  • Example: CME Bitcoin Futures, CBOE Bitcoin Futures

Inverse Futures that trade in USD pricing but settle in BTC

  • Example: Bitmex Quarterly Contract Futures

The profit and loss calculations work slightly different but can arrive at the same result, an example will illustrate it best (using BTC as an example):

Entry Price of BTCUSD= $6,500

Exit Price of BTCUSD= $7,000

Futures that trade in USD pricing and settle in USD

Position = Long 1 BTC contract

PnL = ($7,000 — $6,500) x 1 = $500

Inverse Futures that trade in USD pricing but settle in BTC

Position = Long 6,500 USD contract

(This is the same as long 1 BTC contract since the price of BTC at entry was $6,500 )

PnL = 1/$6,500–1/$7,000 x 6,500

PnL = (0.000153846153846–0.000142857142857) x 6,500 = 0.071428571428571 BTC

However if we assume we immediately liquidated our BTC PnL as well:

PnL (in USD) = 0.071428571428571 x 7,000 = $500

In theory they offer the same protection with the key difference being that inverse futures use BTC in their margin (and settle in BTC), which can be good and bad depending on your purpose. An example structure of the investment is (assuming you wish to be fully hedged):

All cryptocurrency references below are used only as an example.

Calculation explained:

In this case, Bitmex only offers BTCUSD and ETHBTC futures so we need to first convert ETH to BTC. The contracts are denominated in ETH hence:

  1. Short 10 ETHBTC futures
  2. Next we need to factor this into our BTCUSD hedge. So Total short BTCUSD position = $6,500 x 10 + $200 x 10 = $6,700

With this your portfolio should be fully hedged (as long as you make sure to maintain your hedge).

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.

How You Construct This

What you need:

  • An account with a crypto futures exchange.

To construct this hedged portfolio:

  1. First choose which future contract you wish to use. Your decision should probably depend upon which currency you wish to settle in (crypto or Fiat) and fund the relevant exchange.
  2. If you are settling in USD you can look to sell some crypto to fund the account but keep in mind that withdrawal/deposits could take some time to get processed.
  3. Based upon your holdings and what is available on the exchange, you need to calculate which combination of futures contracts you need as well as how many contracts; similar to what I did in the calculation section in the example above.
  4. Monitor your short positions profit and loss so that if you are getting close to your margin call, you will need to deposit more USD or cryptocurrency into the exchange to maintain your short position.
  5. Note depositing into the exchanges can take time and since crypto markets can be very volatile, best to not cut it to close before topping up.
  6. Close out your short position whenever you wish to close out your hedge.
  7. Do note that unlike shorting futures, there can be deviations to the actual price movement of the underlying due to market sentiment/expectations.

Summary

Hedging with futures is best suited for crypto investors that carry the standard coins and want to hedge their exposures an efficient way. A good understanding is highly recommended to fully assess the risk of using financial derivatives.

Pros and Cons for using futures for hedging:

Risks

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.

Just like short selling there are risks to using futures (including exchange default risk). Below is the more common ones I can think of besides those mentioned in short selling:

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).

Deviation In Future Prices (Basis Risk)

Additionally for futures, there is another source of risk which is basis risk. It is the idea that future prices do not move in-line with the spot prices. Without going into detail of the maths/mechanics behind futures, it can be seen that this can be prevalent in the cryptocurrency space because of events like airdrop and forks that can occur during the lifecycle of the futures contract. To make matters worse you also have to asses the default risk of the futures crypto exchange and anything that happens to the particular exchange you are using.

Other Factors

Some futures exchanges have special clauses to protect themselves but can harm your investments hence it is important to read the fine print of your futures contract. One popular one is known as societal loss which I will cover in a separate article.

At the end of the day, holding a futures contract is holding a contract based on crypto prices and is not a 100% replacement to holding cryptos (or shorting it) hence there are additional risks of deviation involved that you need to understand and should be aware of.

#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 concept 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.

How You Construct This

The portfolio construction is the same as inverse futures so you can refer to the previous instructions except you would need an account with crypto futures exchange that offers perpetual futures.

Summary

Just like futures, hedging with swaps is best suited for crypto investors that carry the standard coins and want to hedge their exposures in an efficient way. A good understanding is highly recommended to fully assess the risk of using financial derivatives.

Pros and Cons are the same for futures and swaps so instead I have compared it to using futures instead for the table below:

Risks

As this is the same as futures I will not elaborate on it in the previous section.

#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. Here is a link of the basic mechanism of options for your reference.

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.

All cryptocurrency references below are used only as an example.

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.

How To Construct It

What you need:

  • An account with Deribit (they are the only crypto options exchange at the moment)

The steps to construct this is similar to using futures with a much easier time to monitor/manage (using bitcoin as an example):

  1. Based upon the current price of bitcoin (BTC) and your expected hedging time frame look for the closest in the money (ITM) put option:
  2. For example if BTC is at 6432 and you want to hold it until the end of the quarter then look at the 6500 put option pricing for end of the current quarter. If there isn’t one that matches your time frame then go for the longer dated one e.g. if you want to hedge for 2 months then look for the one that is quarterly and covers your timeframe.
  3. For your chosen ITM put option price check its current price and calculate how much funds you would need to have to deposit to own enough for 1:1 coverage of your BTC holdings.
  4. Deposit the funds into the exchange (probably best to deposit a bit more as buffer in case prices move).
  5. Purchase the put option and hold it until expiration (you could liquidate it in the middle if you wish to but the hedging cost could be more costly depending on the market conditions and liquidity)

Summary

As mentioned hedging with options can be quite complex but also means it can be better tailored for your needs. Hence it could be worth understanding more if you hedge frequently. Instead I have covered the basics here to get you started and provide a fairly different style of hedging.

Pros and Cons relating to the options hedging method described above:

Risks

Same as futures hence I will not elaborate on it. You can click here to read the previous section.

Final Thoughts

Hopefully this has got you thinking about hedging in a different perspective and provided some idea to get you started. If you know of any other innovative ways to hedge feel free to share your thought/ideas with me in the comments section below. (Of course questions are welcome as well).

Extra: Why Do People Hedge?

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:

A Miner

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.

A Fund

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.

A Whale

It isn’t always easy to sell significant amounts of cryptos without spreading market fear if you are a whale as the market may not be liquid enough. Hence an alternative is to put hedges in place so as to reduce your overall exposure as you slowly trickle out your cryptos into the market over a longer period of time.

These are just a few reasons I could think of and am sure there are others.

The post above is for informational and entertainment purposes only. Any and all information perceived through such posts, through either audio, visual, verbal or written means, should be considered the personal opinions, strategies and examples of the author and reflect his or her judgement as of the date of publication, are subject to change, and do not constitute investment or trading advice. No representation or warranty is made by the author respect to the accuracy, applicability, fitness or completeness of the contents of any information. The author of these posts shall not be held liable to any party for any direct, indirect, implied, punitive, special, incidental, or other consequential damages arising directly or indirectly from any use of the contents, which is provided as is, and without warranties of any kind whatsoever, express or implied. Any links or references to third party providers are for informational purposes only and are not warranted for content, accuracy or any other implied or explicit purpose.

Investments and trading strategies are subject to market risks and potential losses and all trading strategies likewise have the potential for profit or loss. Past performance is no guarantee of future results. There can be no assurances that any trading strategy will match or outperform any particular benchmark. No content should be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell any securities mentioned. In all cases, readers should never take any information perceived from this blog at face value and should always do their own due diligence on any materials to form their own opinions and best judgements. A professional advisor should be consulted for personalised investment advice before taking action of any kind. If the reader wishes to apply concepts or ideas contained in any post, such reader takes full responsibility for his or her actions.

© 2018 Cham Ho. All Rights Reserved. Product names, logos, brands, and other trademarks featured or referred to herein are the property of their respective trademark holders.

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Founder & Partner of Unikorn Capital (unikorncapital.com) a crypto investment company. He is also a CFA® charterholder. Telegram: @ChamHo_UC