Hedging

Hedging is a risk management strategy used to offset potential losses in investments by taking an opposite position in a related asset. This section explores various hedging techniques available in the crypto market, focusing on margin (borrowing), options, futures, and perpetual futures contracts. Not all of these hedging strategies might be available in your region.

Margin Trading (Borrowing)

Margin trading allows traders to borrow funds to increase their buying power, enabling them to open larger positions than their capital would allow.

• Short Selling: Borrowing a cryptocurrency to sell it at the current price, with the obligation to buy it back later. If the price decreases, the trader profits from the difference.

Risks

• Leverage: Traders can amplify their exposure to the market (e.g., 2x, 5x, 10x).
• Margin Call: If the market moves against the trader's position, they may need to provide additional funds to maintain the position.
• Liquidation: Failure to meet margin requirements can result in the automatic closure of the position.

Options

Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an asset at a predetermined price before a specified date.

• Types of Options:

  Call Option: Right to buy an asset at a set price.
  Put Option: Right to sell an asset at a set price.

• Premium:
  The premium is the price paid by the buyer to the seller (writer) of the option. It represents the cost of acquiring the option rights.
  Purpose: Compensates the seller for the risk they assume and reflects the option's value based on various factors like time to expiration and volatility.
• Expiration Date: The date on which the option contract expires. After this date, the option becomes worthless if not exercised.
• Types of Options Based on Exercise Style:
  American Options: Can be exercised any time up to and including the expiration date.
  European Options: Can be exercised only on the expiration date.
• Strike Price: The predetermined price at which the option holder can buy (call option) or sell (put option) the underlying asset.

Factors Influencing Option Prices

The price (premium) of an option is influenced by several factors:

• Intrinsic Value: The difference between the underlying asset's price and the strike price.
• Time Value: The value of having time until expiration, reflecting the possibility of the option becoming profitable.
• Volatility: Higher volatility increases the chance of the option being profitable, raising the premium.

Risk

• For Option Buyers: The maximum loss is limited to the premium paid for the option.
• For Option Sellers (Writers):
  Call Option Seller: Faces potentially unlimited risk if the underlying asset's price rises significantly.
  Put Option Seller: Risk is substantial, limited to the strike price minus the premium if the asset's price drops to zero.

Simple Example with a Call Option

Investor's Perspective

You believe that the price of ABC Cryptocurrency will rise above $55 in one month. To capitalize on this expectation with limited risk, you decide to purchase a call option.

Calculating Gains and Losses

Possible Outcomes at Expiration

Key Takeaways

• Limited Risk: As a buyer of a call option, your maximum risk is the premium paid.
• Leverage: Options allow you to control a larger position with a smaller amount of capital.
• Expiration Styles Matter:
  • American Options: More flexibility but may have higher premiums.
  • European Options: Less flexibility but often cheaper.
• Option Pricing: Influenced by intrinsic value and time value, affected by factors like volatility and time to expiration.
• Breakeven Point: Important to know at what underlying price you'll start making a profit.

Futures Contracts (Concept)

A futures contract is an agreement between two parties to buy or sell a commodity, such as oil or wheat, at a predetermined price on a specific date in the future. Originally used by farmers and producers to lock in prices and manage risk, futures contracts allow traders today to speculate on the price movement of various assets without owning them directly.

• Leverage: Futures contracts often involve leverage, allowing traders to amplify their market exposure with a smaller initial investment.
• Settlement: Contracts can be settled in cash or through the physical delivery of the underlying commodity.

Protecting Against Price Changes

• Scenario: Imagine you are a wheat producer and want to protect against potential price changes in wheat in the future.
• Action: By selling a futures contract at today's price, you lock in that price for your future harvest.
• Outcome: You ensure that you receive a guaranteed price for your wheat, regardless of market fluctuations.

Perpetual Futures Contracts

Perpetual futures, also known as perpetual swaps, are similar to traditional futures contracts but have no expiration date, making them particularly popular in the crypto market. Unlike traditional futures, perpetual futures are typically cash-settled, meaning there is no actual buying or selling of the underlying cryptocurrency.

Key Features

• Funding Rate Mechanism: To keep the contract price aligned with the spot market price, periodic payments (funding rates) occur between traders holding long and short positions.
• High Leverage: Perpetual futures typically offer significant leverage, which can enhance both potential gains and risks.
• No Expiry: Positions can be held indefinitely, as long as the trader has sufficient margin.

Using Perpetual Futures for Hedging

For example, if you hold an asset and expect a potential decline in its price, perpetual futures can help you protect your investment.

Shorting with Perpetual Contracts

• Scenario: You currently own BTC and expect its price to fall.
• Action: Open a short position with perpetual futures contracts on BTC.
• Outcome: Any losses in your BTC holdings could be offset by gains in the short position, reducing your overall risk.

Additional Info

• Understanding your margin requirements is crucial when engaging in leveraged trading. Before entering a position, it's essential to be aware of your margin call and liquidation levels to avoid unexpected closures of your positions.
  Kraken margin call and margin liquidation levels.
• Not all hedging strategies may be available in your region. Some countries have regulatory restrictions that prohibit or limit trading in futures, options, or leveraged products.
• Futures and option allows you to hedge without liquidating your crypto assets, which could have tax implications or affect long-term investment strategies.