Hedging is a popular strategy in traditional financial markets. Investors and fund managers know about the importance of hedging against investment risk. With cryptocurrency trading volumes growing strongly over the last few years, there is more interest from funds and retail investors in crypto assets. Consequently, interest in crypto-specific hedging is growing as well. However, hedging cryptocurrency investments is quite different from the hedging strategies used for the stock market. In this article, we cover the topic of crypto hedging and its unique nature.
Specifics of Hedging in Crypto
Hedging refers to a range of strategies used to offset the risk of investing in a particular asset. Typically, a risk associated with an asset, such as a commodity, stock, or foreign currency, is hedged against by using financial products that are expected to have a negative correlation with that asset.
Probably the simplest and best-known example of hedging in the world of finance is using gold as a hedge against the USD. Some investors believe that gold and the USD are negatively correlated, at least most of the time. Thus, they might invest in both gold and USD to protect their overall investment.
Most seasoned traders and investment funds use far more sophisticated strategies and products than the gold and USD example above. In fact, active hedging strategies in the commodities and stock markets typically involve the use of derivative products, particularly futures and options.
However, the cryptocurrency market has its own specifics that make direct application of hedging strategies used in the stock market problematic or inefficient.
Firstly, futures and options products for cryptocurrencies are much more limited in terms of variety compared to similar products in traditional financial markets. For example, most altcoins simply do not have any futures or options available for them.
Secondly, the cryptocurrency industry has some unique investment mechanisms, such as yield farming, that have no direct analogues in traditional finance.
Thirdly, the cryptocurrency market is known for its wild volatility levels, which calls for somewhat different hedging strategies than simply using options or futures.
What Are the Best Hedging Strategies for Crypto?
Given the relatively novel nature of the cryptocurrency market, there are a wide variety of ways, some quite controversial or experimental, how traders can hedge against investment risk. From this variety, we have distilled the five best hedging strategies, which include:
1. Using crypto futures and options. This is a direct replication of the typical hedging approach used in traditional financial markets. Bitcoin and other leading coins have futures and options products associated with them available on the leading derivative crypto exchanges as well as some traditional exchanges. This strategy might be applicable specifically for Bitcoin as the leading crypto with the biggest variety of futures and options products on offer.
2. Yield farming. Yield farming involves investing crypto funds in various liquidity or staking pools on decentralized finance platforms to earn interest. While yield farming might be risky, it is possible to use it for hedging purposes. For example, most liquidity pools offer higher interest on more volatile coins. If you have invested in a risky coin, you could hedge against that risk to some degree by earning better short-term interest paid on it.
3. Dollar Cost Averaging (DCA). DCA is a straightforward and simple investment strategy based on dividing your planned investment into smaller chunks and investing each part at regular intervals. For instance, let's say you decide to invest in Bitcoin for a total of $120,000 USD over the next one year. Instead of plunging the entire amount into the asset at once, you would invest $10,000 USD once a month for the next 12 months. An important part of the DCA strategy is that you should not be overly concerned with the current price of the asset and proceed with your regular investment regardless of market developments.
The core principle behind DCA is to help investors avoid trying to time the market. Some investors spend an inordinate amount of time researching the market and trying to find the optimal time to buy the asset of interest. However, many in the trading industry assert that “time in the market beats market timing,” implying that it is more profitable to invest without searching for optimal investment times.
DCA is a great strategy for less experienced investors as well as for those who are focused on longer-term investment goals. If you are a seasoned trader or fund manager and your goals are of a short-term or medium-term nature, you may use the other hedging strategies.
4. Hold on to your dear life (HODL). This is a well-known crypto investment strategy. Probably no other crypto investment approach has attracted more debate than HODL. It is based on investing in a crypto asset with a long-term perspective and not selling before your pre-determined long-term investment period is over. This strategy often works great in the crypto market due to its predisposition to volatility and hype.
5. Investing in popular stablecoins. If an individual or a fund forecasts that they might need ready access to fiat currency in the future, investing a part of your crypto portfolio in stablecoins is a good hedging strategy. It is recommended to stick with the leading high-cap stablecoins (USDT, USDC, BUSD) as many smaller cryptocurrencies might struggle to maintain their fiat currency pegs long-term.
Out of the five strategies above, the first two – options/futures and yield farming – are relatively high-risk hedging strategies, while DCA, HODL, and investing in stablecoins are more suitable for the risk-averse investor. Whatever strategy you choose, always ensure that you combine your market analysis with a thorough study of the target asset’s Social Media sentiment. For this purpose, PUMP from Zenpulsar is your indispensable friend. Happy trading and hedging against risks!