Contract Hedging
In the cryptocurrency market (crypto circle), hedging refers to the use of financial instruments or strategies to offset the risks of positions and reduce the impact of price fluctuations on the portfolio. Due to the extreme price volatility of cryptocurrencies (daily price changes often exceeding 10%), hedging strategies are commonly used to protect profits, reduce losses, or lock in future prices. The following is a detailed analysis of hedging in the crypto circle:
I. Core Objectives of Hedging
Reduce Price Volatility Risks Avoid significant losses caused by the sharp decline of a single cryptocurrency position (e.g., hedging against the downside risk of Bitcoin when holding it).
Lock in Profits or Costs
Profit Locking: Hedge profitable spot positions to prevent price corrections from eroding profits.
Cost Locking: Hedge future purchase plans to avoid increased costs due to price hikes (e.g., institutional hedging before regular investments).
Market-Neutral Strategies for Bull and Bear Markets When it is difficult to distinguish between bull and bear markets, achieve "market neutrality" through hedging to stabilize profits regardless of price direction (e.g., arbitrage strategies).
II. Common Hedging Tools and Strategies
1. Futures Contract hedging (most commonly used)
Principle: Offset price volatility risks by opening futures positions opposite to spot holdings.
Example:
Hold 10 BTC spot (cost: $20,000 per coin), and worry about price declines? Short 10 BTC in the futures market (assuming the current price is $30,000).
If BTC falls to $25,000, the spot loss is $5,000, but the futures short position gains $5,000, achieving hedging.
Operation Methods:
Short Hedging (shorting futures): Suitable for spot long positions to hedge against downside risks.
Long Hedging (longing futures): Suitable for planned future spot purchases to hedge against price increases (e.g., locking in costs before regular investments).
Advantages:
High liquidity, supported by major exchanges (e.g., Binance, OKX);
Flexible leverage (1-125x leverage options to reduce margin requirements).
Disadvantages:
Require margin deposits, with high liquidation risks (especially at high leverage);
Price divergence ("basis risk") between futures and spot may affect hedging effectiveness.
2. Option hedging (non-linear risk hedging)
Principle: Obtain insurance against price fluctuations at a limited premium cost by buying put options (Put) or call options (Call).
Example:
Hold ETH spot and buy an ETH put option (strike price: $1,800, premium: $50).
If ETH falls to $1,500, the put option profits $300 ($1,800 - $1,500 - $50), offsetting the spot loss.
Strategy Types:
Protective Put Options (Collar Strategy): Buy put options to hedge downside risks while selling call options to reduce premium costs (suitable for ranging markets).
Straddle/Strangle Strategies: Buy both call and put options simultaneously to hedge against high volatility (suitable before major events like project upgrades or regulatory announcements).
Advantages:
Limited risk (maximum loss is the premium), unlimited profit potential;
Flexibility to adapt to different market expectations (e.g., changes in volatility).
Disadvantages:
High premium costs (deep out-of-the-money options have lower costs but weaker hedging effects);
Options need to be reopened after expiration, accumulating long-term hedging costs.
3. Stablecoin hedging (risk-free hedging)
Principle: Reduce cryptocurrency exposure by converting part of the assets into stablecoins (e.g., USDT, USDC).
Example:
An 80% cryptocurrency and 20% stablecoin portfolio. During market crashes, the stablecoin portion hedges against overall drawdowns.
Strategy Variations:
Dynamic Rebalancing: Set thresholds (e.g., sell part of the holdings for stablecoins when cryptocurrencies exceed 90% of the portfolio; buy cryptocurrencies when below 70%).
Advantages:
Simple operation, no complex tools required;
Fully hedges against systemic cryptocurrency risks.
Disadvantages:
Forego potential upside gains (stablecoins have no appreciation potential);
Incur fiat currency conversion fees.
4. Inverse ETF hedging (passive hedging tool)
Principle: Achieve automatic hedging by holding ETF tokens inversely correlated with the underlying asset price (e.g., SQQQ, BTC3S).
Example:
Hold BTC spot and buy BTC3S (3x short ETF). When BTC falls 10%, BTC3S rises approximately 30% to hedge the spot loss.
Notes:
Inverse ETFs are typically based on futures contracts and suffer from "erosion" (daily rebalancing causes net value decay), unsuitable for long-term holding;
Only suitable for short-term hedging (e.g., 1-3 days of volatility).
5. Cross-currency hedging (correlation hedging)
Principle: Hedge risks using low or negatively correlated currency pairs.
Example:
Hold high-volatility small-cap coins (e.g., MEME coins) and pair them with low-volatility gold-backed coins (e.g., PAXG) or algorithmic stablecoins (e.g., DAI) to reduce overall portfolio volatility.
When Bitcoin has a strong positive correlation with U.S. stocks, allocate assets negatively correlated with U.S. stocks (e.g., VIX index tokens).
Data Reference:
Bitcoin's correlation with gold is ~0.3, with S&P 500 ~0.6, and with USDT -1 (perfect negative correlation).
6. Arbitrage hedging (risk-free arbitrage)
Principle: Lock in profits by simultaneously opening long and short positions using price differences or arbitrage opportunities across markets/currencies.
Types:
Cash-Futures Arbitrage: When futures prices are higher than spot prices, short futures and long spot, profiting from price convergence at expiration;
Cross-Exchange Arbitrage: Buy BTC on Exchange A ($30,000) and sell on Exchange B ($29,500) when prices differ;
Triangular Arbitrage: Exploit exchange rate deviations among three currencies (e.g., BTC/USDT, BTC/ETH, ETH/USDT) for cyclic trading profits.
Conditions:
Price differences must cover transaction fees and slippage;
Requires fast execution (automated programs are more effective).
III. Selection and Combination of Hedging Strategies
Long-term spot holding, fearing crashes
Futures short + put options
Hold 100 ETH, short 50 ETH futures + buy put options
High short-term volatility uncertainty
Straddle option portfolio (buy Call + Put)
Hedge multi-directional volatility before major policy announcements
Locking partial profits in a bull market
Sell part of spot for stablecoins
Convert 50% of profitable BTC to USDT, retain 50% position
High volatility risk in small-cap coins
Inverse ETF + stablecoin portfolio
Hold SHIB, pair with 10% SHIB3S + 20% USDT
IV. Costs and Risks of Hedging
Direct Costs
Futures/options trading fees, funding rates (perpetual contracts);
Option premiums, ETF management fees.
Hidden Risks
Basis Risk: Deviations between futures and spot prices lead to incomplete hedging (e.g., futures crash while spot declines less);
Liquidity Risk: Low liquidity in small-cap futures/options markets causes high slippage, making precise hedging difficult;
Over-hedging: Full hedging eliminates upside gains and may even cause losses due to tool costs.
Leverage Traps
High leverage in futures hedging may trigger liquidation due to small price fluctuations, amplifying losses instead.
V. How Retail Investors Can Practice Hedging
Clarify Hedging Objectives
Protect profits or prevent crash losses? Objectives determine tool selection (e.g., options for profit protection, futures for crash prevention).
Start with Small-Scale Testing
Use 10% of the position to test hedging effects before scaling up.
Prioritize Low-Leverage Tools
Novices should avoid leverage exceeding 5x and prefer spot + options combinations (e.g., buying put options).
Monitor Market Correlation Changes
Bitcoin's correlation with U.S. stocks may change with macroeconomic conditions (e.g., rising during rate hike cycles), requiring dynamic adjustment of hedging ratios.
Leverage Analytical Tools
Use Delta values to calculate option hedging ratios (e.g., 2 put options with Delta=0.5 to hedge 1 spot);
Monitor the long - short ratio of contracts across the network through Coinglass to judge the extreme values of market sentiment.
VI. Limitations of Hedging
Inability to Eliminate Systemic Risks Most hedging tools (except stablecoins) may fail simultaneously in a full-scale cryptocurrency market collapse (e.g., comprehensive regulatory bans).
Balance Between Risk and Reward Perfect hedging means giving up upside gains. In practice, balance "risk control" with "return expectations" (e.g., hedge 50% of the position while retaining 50% exposure).
Time-Dimension Constraints High long-term hedging costs (e.g., futures rollover fees, options renewal fees) make it more suitable for medium-to-short-term strategies.
Conclusion
Hedging is an essential skill for professional crypto investors, fundamentally aiming to exchange "limited costs" for "controllable risks." For retail investors, mastering basic methods like "dynamic spot-stablecoin balancing" or "buying put options" can effectively reduce volatility impacts. Remember: Hedging is not about predicting markets but about surviving extreme conditions to await genuine investment opportunities. With high uncertainties in the cryptocurrency market, rational hedging enhances long-term survival rates more than blind chasing of trends.
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