Protect your crypto investment from downside risks with the right tools
Bitcoin bulls have been having a hard time as the leading cryptocurrency has been following a bearish path since reaching the year high of $13,900 level in late June. As the price correction continues, traders have been asking how to hedge their BTC long positions. Thanks to the booming crypto derivative markets, participants can now take advantage of the increasingly popular perpetual swap and futures contract products to have better control of their risk exposure.
BTC Short-term Bearish
Despite the long-term bullish case is still strong, a persistence of short-term bearishness is seen here on a daily BTC/USDT chart. In late June, the pair traded above $13,900 level for the first time in more than a year, however, the pair has failed to break that level in mid-July, and that became a resistance. A double top pattern has formed and followed by a downtrend. Recently, the pair failed to stay above the double top neckline at around $10,400. On top of that, daily RSI still below 50 and daily MACD remained in the bearish zone.
Derivatives and Risk Management
In light of the recent price correction in BTC, managing risk by using bitcoin derivatives is now a topic that perhaps everyone wants to revisit. If you were an investor in the traditional financial market, you will be no stranger to trading derivatives.
In the textbook, a derivative is a financial security with a value determined by its underlying asset. It is a contract that involves two or more parties, and the underlying assets could be stocks, bonds, commodities, currencies, interest rates, or market indices.
What makes derivative such a popular instrument? Because it can be used to hedge a position, speculate on the directional movement of the underlying asset, or give leverage to holdings. It’s also a versatile tool when it comes to risk management. Many financial institutions are constantly trading derivatives like swaps and forwards, as part of their risk diversification strategies.
Derivatives in Crypto
The markets of crypto derivatives are relatively new and small when compared with the traditional ones, but that doesn’t make it less lucrative. Like equities futures or interest rate swaps, BTC derivatives offer shelter from volatility and over the fluctuation of the crypto markets. It can also act as a hedging tool to offset potential losses. On top of that, traders can utilize derivatives to speculate on the prices of cryptocurrencies with leverage, maximizing the potential profits. There are three major kinds of derivatives in the crypto world. (1). Perpetual Swaps; (2). Futures contracts; and (3). Options
Although the growing downside risk of BTC could eventually create a buying opportunity for BTC bulls in the future, however, the BTC negative sentiment has built up, and for risk management, investors are advised to review its hedging and arbitrage strategies. Hedging involves the use of more than one concurrent bet in opposite directions in an attempt to limit the risk of serious investment loss. First, let’s review the differences between hedging strategies.
Let’s take futures contracts as an example of hedging.
There are still some other factors that will influence the overall hedging strategy, such as the expiration date, the decision of being long or short and the number of contracts.
Protecting Long Positions
Perpetual swap is another structured instrument that investors can leverage on. Let’s assume a bitcoin is now trading at $9,500 in the spot market, and a BTC perpetual swap is trading at $9,600. An investor could buy a bitcoin in the spot market with $9,500 and open a short position worth the same value ($9,500) in the perpetual market at the same time.
- When the prices of BTC go up, investors could take profit from the spot market.
- When the prices of BTC go down, investors could close the short position of the perpetual swap and take profit from that, make up for the lost in the spot market.
However, traders should also consider the funding and settlement factors if holding the swap for an extended period is part of their strategy.
Arbitrage is the practice of trading a price difference between more than one market for the same good in an attempt to profit from the imbalance, it involves both a purchase and sale within a very short period. Let’s assume the same scenario when a bitcoin is trading at $9,500 in the spot market, and a BTC perpetual swap is at $9,600. An investor purchases a bitcoin in the spot market with $9,500 and opens a short position worth the same value ($9,600) in the perpetual market at the same time.
- Investors can take profit if the spread between the two narrowed.
- If the spread is widened, the unrealized P&L of the swap turns negative. In this situation, investors can wait for the settlement due. The mark price of swap usually calculated based on the spot price, so the mark price would be very close to the spot, and the profit would be about $9,600–$9,500=$100
- When the spot price is higher than the swap price, the total profit exceeds $100.
Hedging is not the pursuit of risk-free trades. Instead, it is an attempt to reduce known risks while trading. It’s an important strategy in the traditional financial markets and business management, and crypto traders can adopt the practices that have been widely used in equities, FX and commodities trading. Much like any other risk/reward trade, hedging results in lower returns for the party involved, but it can offer significant protection against downside risk.
Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involves significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.
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