Don't Like Using a Stop Loss? Here's a Quick Guide to Hedging
You can manage risk in a multitude of ways, one of which is by hedging your investments. Here's everything you need to know about hedging.
In previous articles on risk management, we have covered almost all other ways of limiting risk when trading, apart from hedging. I left hedging your bets for last as it rarely pertains to new traders or investors and is a bit more complicated to execute than other techniques. Let’s start with the definition of hedging.
What does it mean to hedge your position?
“To hedge, in finance, is to take an offsetting position in an asset or investment that reduces the price risk of an existing position. A hedge is therefore a trade that is made with the purpose of reducing the risk of adverse price movements in another asset. Normally, a hedge consists of taking the opposite position in a related security or in a derivative security based on the asset to be hedged.” Investopedia
How do you hedge in practice?
Since this is a Bitcoin-focused publication, we’ll concentrate on learning to hedge your Bitcoin investments.
Imagine a scenario where you buy one Bitcoin intending to hold it for a few years or decades. You believe the price is destined to go up in the long term, but you are also an intelligent investor and realize that:
Nothing is certain in this world.
Anything can happen at any time.
You must always manage risk and protect your money.
Bitcoin is a volatile asset that regularly drops by 50-70%.
There is a non-zero chance that something unexpected happens, and it goes to zero.
Step number one - the buy.
First, you have to purchase one Bitcoin. The same goes for any other asset, the lesson is universal, and this is just an example.
You create an account on an exchange, wire your money and buy one Bitcoin. You are now a proud owner of Bitcoin, a true visionary investor, and one of the cool kids.
The money you invested is substantial, and you want to protect yourself so that you won’t lose it if Bitcoin drops significantly. You can manage risk in many ways. You could use a stop loss, or you could have been very careful with the size of your position, making sure not to invest more than a certain percent of your whole portfolio in one asset.
Step number two - choose your hedge.
There are generally two different hedging systems we can use:
We can open a short position on our asset, selling an equal amount of Bitcoin (in our case) while still holding on to our core investment.
We can buy an asset with the tendency or design to go in the other direction than our invested asset. If one goes up, the other goes down. We buy equal amounts, and we are hedged.
Using short selling as a hedge system.
Once you have your Bitcoin, you can keep it on the exchange (not recommended) or transfer it onto your wallet, preferably a paper or hard wallet.
Keeping your Bitcoin on the exchange simplifies hedging but exposes you to third-party risk.
Transferring your assets to your wallet, while smarter and safer, does complicate things considerably and requires some math.
The simple way.
If you decide to keep your Bitcoin on the exchange and the exchange offers the option of shorting Bitcoin, the rest is as easy as it gets. You simply sell some Bitcoin as a hedge, using a short position.
You have now bought one Bitcoin and used it as a margin to short-sell one or less Bitcoin. It’s simple, straightforward, and you are safe from market volatility.
The smart way.
If you had transferred your Bitcoin into self-custody, as a good Bitcoiner would, you can now either leave some Bitcoin on the exchange or transfer some other currency onto the exchange (dollar, euro).
You need to have some money available in your account for margin. This path complicates things, as you now need to use leverage.
Learn about leverage trading, as it’s more tricky than you might think, but it can also be a force of good and risk management if done right.
If you decided to use 10% of the value of Bitcoin for your hedge, at the moment of writing, roughly 3,000 USD, you would be using a 10 x leverage to open a short position on one Bitcoin (worth 30,000 USD). Can you spot the problem yet?
What happens to your position if the price increases by 20% and you use a 10% margin? You get liquidated long before that happens! The money you had in your account is now gone.
That means that if you have chosen to use leverage for hedging, you will have to be very careful when you hedge (open a short) and manage your risk carefully. You’re essentially trading.
You can avoid the danger of liquidation by filling up your account with an equal amount of money to your hedge, so in our case, 30,000 USD, and then opening a short for one Bitcoin.
In shorting, you are making money as the price of a shorted asset goes down. The further the drop, the more money you make. If the price goes up, on the other hand, you are losing money. It’s an upside-down world, essentially.
If you had kept your Bitcoin on the exchange, as the value of your spot Bitcoin rises, the value of your hedge short position lowers. When the Bitcoin price drops, your short is making money. If you hedged one for one, they cancel each other out.
You are effectively hedged since you own one Bitcoin and have now also opened a short position against Bitcoin. The dollar value of your investment is secure. You cannot lose money if the price goes down.
Coincidentally, you also can’t make money if the price of Bitcoin rises!
If you hedge one for one, you have effectively created a stablecoin. You’ve decided that this is what one Bitcoin is worth. But how does that make any sense if you want to make more money as the price of Bitcoin rises with time? The short answer is - it doesn’t.
Complete or partial hedge.
You don’t have to hedge one for one, so if you bought one Bitcoin, you open a short position of one Bitcoin. Instead, You can open a partial hedge for 10%, 30%, or 50%.
That ensures that you are managing risk and will take less of a hit if the price of your investment plummets.
If, on the other hand, the price rises, you’ll be losing money, but in limited quantities, as you have only partially hedged.
If you had opened a hedge of 50% of your spot investment, for example, you would be only partially protected if the price of Bitcoin drops. Better than nothing, but you’re still down on your investment. Here’s an example of a 20% correction.
You won't be happy if the Bitcoin price drops by 70%.
If you were hedged one-for-one, you wouldn’t have lost anything, and if you had no hedge, you would have been down 70% of your investment.
Hedging by buying an uncorrelated asset.
In simple terms, this could be deemed diversification, but it must be done with genuinely uncorrelated assets. Ideally, for hedging, assets that go in the opposite direction price-wise. When one goes up, the other falls.
We encounter the same problems as with hedging using short selling. Suppose we had chosen truly uncorrelated or counter-correlated assets and bought one-for-one. In that case, we’d effectively hedged ourselves, but now we are stuck in limbo and can’t make any money.
We also add the risk of these assets breaking their non-correlation relationship with our asset, and both can eventually sink to lower prices. We are adding uncertainty and risk to some extent.
However, we are avoiding the pitfalls of using leverage and preventing the possibility of liquidation, which is no small matter. If you manage billions, you might not have a choice but to use uncorrelated assets for hedging, as anything you do moves the market.
I don’t see any sense in using other assets as hedges, as it only complicates things unless you genuinely don’t want to use leverage in your hedging or can’t for some reason.
When does hedging your investments make sense?
So, if it doesn’t make sense to hedge one-for-one, and if you can’t make money with the rise in Bitcoin because you are hedged, what’s the point?
Good question. As you can see, hedging is more complex than we may believe. If we want to be truly protected, we open ourselves up to third-party risk and essentially decide that we will not make money with our investment.
In reality, our hedges must be well-timed and flexible.
We must be quick to protect our investments in a downturn and make money when the price goes up.
In practice, one should hedge their investment at the first sign of trouble in the market, ideally before we enter a bear trend or a deep correction.
Alternatively, one could build a hedge as the price goes up, near the expected top of the bull trend.
But here’s the thing with timing. We all want to do it, but most fail miserably. Timing the market is challenging.
If we aren’t used to taking a loss in trading or investing, we might get into trouble by holding onto trades or hedges that we shouldn’t.
Hedging should be used seldom and carefully.
It’s not as straightforward as using a stop loss or proper position sizing and can end up biting us in the ass. If you’re not an advanced trader or investor, it’s perhaps best to forget about hedging unless:
You predict prices will be lower in the near future but don’t want to sell your assets. It might still be wiser to sell your investment without further complicating things and rebuy them later.
You are happy with keeping the price of your asset where it is (with a one-for-one hedge). That has various purposes, like taking on a foreign currency loan and hedging to ensure you’re not exposed to volatility risks. Suppliers or manufacturers often use hedging to guarantee themselves a good price, etc.
You manage size that prevents you from using other methods of managing risk. Using stops on positions ranging in millions is quite problematic.
Traders often look toward hedging as an alternative to using stop-loss orders.
We don’t like the pain of taking losses in trading, and we hope that hedging will protect us while we can wait out the storm. It can work, but our inability to take a calculated loss in trading will eventually bite us, and we will end up losing more money sometime down the line.
I would suggest playing with small amounts first to get a feel for hedging, and don’t forget that expenses and fees are involved. Those can make or break the rationality of a hedge.
Best of luck out there.
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