Hedging is a very useful investment tool, it refers to the use of a virtual contract to reduce the risk of adverse price movements in an asset. A hedge consists of taking an offsetting position in a related security. Miners, Cryptocurrency Holders and Future Traders can use hedging to their advantage in achieving the purpose of securing the current value of the cryptocurrencies or the future purchase price.
1. What is hedging?
When a trader buys (or sells) cryptocurrency and conversely sells (or buys) the same number of futures contracts, it is called hedging. The purpose of hedging is to reduce or to eliminate the risks of price fluctuation. Hedging consists of Long Hedge and Short Hedge. The purpose of a Long Hedge is to avoid the risk of a price increase, while a Short Hedge is to avoid the risk of a decrease in price.
2. What are the principles of hedging?
i. Opposite Position
If a trader currently holds a cryptocurrency asset and would like to secure the current value, he will need to enter a short position. If a trader wants to increase the cryptocurrencies holdings at a fixed price, he will need to enter a long position.
ii. Same Instruments
The trader must open opposite position of a contract with the same instrument.
iii. Same Quantity
If a trader holds 2 Bitcoins in his/her position, the opposite position of the Bitcoin contract must have a value of 2 Bitcoins.
iv. Time Consistent
The date and month of the opposite position of the Bitcoin contract must be consistent with the initial position. The price may fluctuate widely according to the month and date.
3. Example
1) Short Hedge
Current Holdings:
A bitcoin miner is expected to mine 2 BTC in one month, the current BTC price is traded at 10,000 USDT/BTC. The BTC contract price must be 10,000 USD.
To prevent price fluctuation, miners need to open a Bitcoin contract for opposite position in order to secure the current Bitcoin value: 2BTC*10000USD/BTC=20000 USD
Short Hedge using Perpetual Contract:
The value of a BTC contract is 1 USD.
Number of Contracts for Short = 20000USD/1USD=20000 Contracts;
Let's assume that a month later, the price of BTC decreases to 8000 USD/BTC;
The profits generated by the contract = (1/8000-1/10000)*1*20000=0.5BTC;
The number of BTC that a miner can sell: 2+0.5=2.5BTC;
Selling price: 8000USD/BTC;
The profits: 2.5*8000=20000USD.
After placing a Short Hedge, the value of the cryptocurrency asset will be guaranteed if there is a fall in price. However, if the price of the cryptocurrency asset rises, the miner will not enjoy the appreciation brought about by the increased in value.
2) Long Hedge
Secure the future purchase price:
A trader wishes to buy 2 Bitcoins in a month's time at the current purchase price of 4,000USD per Bitcoin.
In order to secure this ideal purchase price of 4,000USD per Bitcoin and to prevent the price from rising in the coming month, he has to enter a Bitcoin contract for the price at 4,000USD: 2BTC*4000USD/BTC=8000 USD
Long Hedge using Perpetual Contracts:
The value of a BTC contract is 1 USD
Number of Contracts for Long = 8,000USD/1USD=8,000 Contracts;
Let's assume that a month later, the price of BTC increases to 5000 USD/BTC;
The profits generated by the contract =（1/4000-1/5000）*1*8000=0.4BTC;
The number of BTC that a trader needs to buy: 2-0.4=1.6BTC;
Market price: 5,000USD/BTC;
Purchase price: 1.6*5000=8000USD.
After placing a long hedge, the value of the cryptocurrency asset is guaranteed should there be an increase in price. However, if the price of the cryptocurrency falls the trader will not enjoy the benefits of buying the cryptocurrency at a lower price.
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BHEX Team
3 December 2019