The concept of hedging is quite straightforward.
You own a certain asset but you want to be protected as much as possible from any value fluctuations that may occur. Not just so that your overall wealth remains intact but also so you can enjoy better nights of sleep.
Hedging is like buying insurance against the unexpected. But just like with everything else, hedging comes at a cost.
Taking Profit Home
Suppose the markets treated you well in 2019 and you earned a decent profit in Bitcoin (BTC). Chances are that if BTC goes down against your home currency (e.g. USD) in the next couple of months, your profit will be slipping through your fingers from a USD point of view. However, if it goes up, then your USD equivalence will be going up as well.
But if you don’t want to gamble away your hard-earned BTC, you may want to hedge your profit immediately as soon as you realize it.
Example: let’s say your realized profit for a particular trade was 1 BTC. At that time BTCUSD was trading at 8000USD. Suppose that BTC depreciates against USD from 8000 to 7000 in the week following the trade, your USD equivalence of the profit would then decrease from 8000 USD to 7000 USD. On the other hand, if BTC appreciates against USD from 8000 to 9000 in that week, your profit would then also increase from 8000 USD to 9000 USD.
So what you want to do now is to convert your BTC into USD, locking down a fixed USD amount (8000 USD in this case) as soon as you’ve realized your profit. It may sound quite natural to do so, but people call it hedging in the financial world just to make it sound sexy.
Entering the Arena
If you missed the boat last year and would like to enter the game now, here is something you need to watch out for.
Some trading pairs are priced against other cryptocurrencies instead of your home currency (e.g. USD). If you are eyeing trading pairs like ETH/BTC, you need to own BTC first to play the game. That means you need to buy BTC or ETH to gain exposure which means you are exposed with either currency against USD (if you live with USD). In order to get rid of that unwanted exposure, you will want to hedge whatever amount you’re bringing to the table. Otherwise, the chips cashed-in against USD may have succumbed to volatility by the time you’ve earned your profit.
Let’s say ETH/BTC is now trading at 0.020 and BTC/USD is at 8000, and you have a view that ETH will appreciate against BTC. So you convert 8000 USD to 1 BTC and that 1 BTC to 1/0.020 = 50 ETH. It turns out that your view is correct and ETH appreciates against BTC to 0.021 in a week. Great! You now have 50*0.021 = 1.05 BTC in total. But in that same week, BTC has depreciated against USD to 7000. So your total 1.05 BTC is now equivalent to only 7350 USD, which is a 650 USD loss compared to your starting 8000 USD!
So even though your view is correct, without hedging the exposure of rates, you may still lose in your home currency. How should you hedge the BTCUSD exposure?
Here is a simple way to hedge your exposure using BTC/USD perpetual futures:
In addition to your long position in ETH/BTC, you also short 8000 BTCUSD futures contracts at 8000 as your hedge.
After that week, in which BTC depreciated against USD from 8000 to 7000, the profit from this futures position is (1/7000-1/8000)*8000*7000 = 1000 USD. So the total profit from both the ETH/BTC position and the BTCUSD futures position is 1000-650 = 350 USD. In this case, we hedged the original 8000 USD exposure on the movement of BTCUSD to protect our capital while we are taking a trade on ETH/BTC. By executing the hedge, we don’t have to worry about any BTC/USD price movements when we are speculating on ETH/BTC.
Let’s explore the cost of hedging, to understand the nuts and bolts underlying the process.
There are various costs associated with hedging any exposure. In the above example, the exposure of BTC/USD is hedged by entering into a BTC/USD perpetual futures contract. One of the costs associated with futures trading is the margin funding cost, which is calculated on the basis of the funding rate (see About Funding Rate for more details on the calculation of costs based on funding rate). The graph below shows the variation of AAX funding rates of BTC/USD futures:
When the funding rate is positive, the traders who long the futures will have to pay the funding cost to the traders who short the futures, and vice versa.
Let’s return to the above example in which we are hedging our BTC/USD exposure by shorting 8000 BTC/USD futures contracts at 8000 for a week. Suppose we entered the short position at 2019-Dec-10 09:00 AM and held to 2019-Dec-15 09:00 AM.
Based on the corresponding funding rate:
Remember, if the funding rate here is positive, long pays short. If it’s negative short pays long.
So the funding cost we need to pay while holding this short position of BTCUSD futures is then 1 USD * 1/8000 * (0.02% * 14 – 0.02% * 1) = 0.0026 BTC. In this case, we effectively hedge our BTC/USD exposure by paying this relatively small amount of cost. If you can detect the Easter egg, you may notice that it’s possible that you could end up getting paid if the funding rate is in your favor, but we will leave that for another article.
What we’ve discussed here is so-called delta-hedging. In options trading, there are other kinds of hedging to eliminate the exposure to factors like volatility, interest rates, or the change of delta. You can even hedge a futures contract with options.
While ways of hedging can get very creative, in essence, hedging is about getting rid of unintended exposures.