How Hedging Works In Bitcoin Futures

Many traders think they understand hedging strategies in cryptocurrency futures. But the truth is, the concept is as intriguing as the word itself

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Photo by Nick Chong on Unsplash

What is a hedge?

A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security — Investopedia

I can bet, you’ll only get such skull cracker definitions on hedging even after a whole day of scouring the internet.

You’d be more disappointed if you narrowed the search down to hedging Bitcoin futures.

You’d be forgiven for thinking expert traders and investment advisors fail to give a layman step-by-step explanation on purpose.

I have had the same thoughts and finally decided to research the topic.

This is what I have uncovered in the last six months.

Traditional futures are defined as an agreement to buy or sell an asset on a specific future date at a specific price.

The same goes for Bitcoin or cryptocurrency futures.

Though relatively new, Bitcoin futures have created a frenzy, largely because cryptocurrency exchanges provide leverage (credit)and allow traders to bet on any direction BTC price goes.

This, on the other hand, increases the risk of liquidation or what is traditionally known as a margin call.

My demonstrations will be based on trading charts from Binance where I hold a trading account.

I have transferred about $20 in my futures account for this purpose.

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Screenshot by Author

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A trader can open long or short positions in Bitcoin futures. Screenshot by Author

If you are new to cryptocurrency trading, you may have come across traders on Twitter talking about being long or short.

As intriguing as it may seem, it simply means the trader is operating a futures account.

This is an entirely different universe from the widely known spot trading account.

When you spot trade, it means you hold actual cryptocurrencies like Bitcoin and you only earn a profit if the price of the cryptocurrency you are holding goes up.

Most cryptocurrency exchanges offer three types of trading accounts including spot, margin and futures. Its imperative that you understand the differences.

In futures, a trader may opt to go long, which means they will buy a contract worth a certain amount of Bitcoin and hope that BTC price will go up.

If BTC price goes up, they may opt to sell that contract and keep the difference.

If BTC price drops, the trader may opt to sell and take the loss or wait for the next bull run and cash out at a neutral price.

A trader who opts to open a short position is simply betting that the price of BTC will drop. If the price drops, a profit is made on the short position. A short BTC position will record a loss if the price of BTC goes up.

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Hedged BTC position. Screenshot by Author

When your favorite trader says he’s fully hedged, it means they have both long and short positions running concurrently.

Traders do this when its difficult to predict the direction that the market will go.

Assuming the price of Bitcoin suddenly drops, a trader will record a profit on the short position while the long position would be at loss.

The short hedged position can be closed at a profit if a trader feels confident that the price will not drop further.

In the case of the underwater long, the trader would wait for the price to recover back to the area of entry, where he can opt to get out of the long, or wait for the price to move higher and make a profit there as well.

As shown in the above screenshot, I have opened two positions. The long, highlighted in green, has a position size of 0.015 BTC which has gained a profit of $1.11.

The short, in red, has a position size of $0.006 BTC and has accrued a $1 loss.

I entered the long position when BTC price was $9589.99 and the short at $9497.58.

In this case, if I wanted to make profit on both positions, I would cash in the $1.11 profit made so far on the long and then wait for the price to swing back down and cash in the short at a profit as well.

Assuming that a trader got out of a trade because of market uncertainty. This means they would be holding a stablecoin like USD Tether which is not affected by volatility. If then the price of Bitcoin dropped, that trader would also be considered to be fully hedged. This is because they would be able to buy more BTC at a lower price and still make more profit when the price increases. This also applies to spot trading.

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BTC Short after cashing in the Long. Screenshot by Author

Something notable happened here. After I closed the long, the liquidation price swiftly moved from $7376.36 to $13124.14.

As earlier explained, liquidation price is simply where I’d lose my entire investment.

Other than profiting from both market directions, hedging also moves the liquidation price to a safe distance, giving legroom to accommodate huge market fluctuations.

Being able to receive credit to trade with is a very exciting aspect of cryptocurrency futures.

Leverage also comes with an immense risk of liquidation.

The concept of leverage in futures is very simple as you are only required to deposit some form of collateral in the form of cryptocurrency.

In my case, I deposited $20 worth of cryptocurrency.

Some cryptocurrency exchanges allow customers to borrow up to 125 times.

Most pro traders recommend trading with under 10 times leverage to minimize the chance of liquidation. Anything above 10 is a risky gamble.

If you have traded cryptocurrencies, you know for a fact that it’s not easy and money gets burned fast.

And if you are already trading futures, you already know that millions of dollars get wiped out of people’s wallets every single day.

If you are planning to trade Bitcoin futures, just know its a risky endeavor and your account could get liquidated.

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