3 Ways to Hedge your Cryptocurrency Risk Exposure
Whether you’re a speculator, investor or gambler, it’s crucial that you minimize your risk exposure. While prices of Bitcoin may be on the rise, the volatile market has many investors worried.
What appears to be a savvy investment now, could be worthless in just a matter of days. To reduce your risk exposure, it’s crucial that hedge against cryptocurrency volatility.
Before we get started however, let’s take a look at what hedging means. Hedging is a finance term that describes the various strategies used to minimize risk from a volatile market. As you may have read through Bitcoin news, volatile nature of digital currency means that your holdings may suddenly fall in value.
With the value of your investment falling below its original price, you stand to make massive loss. By hedging, you can reduce or entirely avoid risks associated with a volatile market. To get your started, we’ve put together a list of 3 effective hedging strategies.
- Short selling
Investors and speculators live by the ethos of “buying low and selling high” thus earning a profit on the difference. However, short selling is the direct opposite of this and is often used by traders looking to protect themselves from a decline in prices.
Here’s how a typical short-selling transaction looks like
- You “borrow” 1 unit of BTC at USD 8,000 from a broker.
ii Anticipating a fall in BTC prices, you sell this Bitcoin at USD 8,000 to an exchange.
iii. Fortunately, prices of BTC fall to USD 6,000 and you purchase 1 BTC to “repay” the broker.
- Despite a fall in prices, you’ve managed to make a cool USD 2,000 from the sale of BTC.
As can be seen, short selling allows an investor to protect him/herself from price fluctuations. However, short selling is not without its share of problems. A sudden rise in prices may result in you losing much more than your initial investment.
Not to be forgotten, exchanges and brokers often charge additional fees for such services. Before you start short selling, you need to find the right balance between a hedging or holding position.
- Cash out
While short selling can be an effective method of short-term hedging, it doesn’t always work out. In some situations, the simplest solutions may be the best. Cutting your losses and cashing out allows you to walk away with your original investment and some profit.
By cashing out early, you’ll be able to avoid the crash and have something to show for it. However, liquidating your crypto holdings entirely also should be considered to be a last-ditch option. Should the price of cryptocurrencies improve, you’ll end up losing out on a bull market.
Before cashing out, conduct an analysis into existing market conditions to ensure that your decision is an informed one.
- Making use of derivatives
Derivatives are financial instruments typically used in traditional stock markets. These instruments are essential for hedging against market volatility. From futures to contracts and forwards, derivatives are valued on the fluctuating prices of their underlying assets.
Simply, this means that the more volatile the price of an associated asset, the more expensive the derivative. For centuries, derivatives have played an important role in the marketplace.
Derivatives may be in their infancy on the crypto market, but several exchanges have already begun adopting them. A futures contract is a derivative which allows you to buy or sell an asset at a fixed price in the future. Hence, should you predict a fall in crypto prices, a futures contract allows you to sell your cryptocurrencies at a predetermined price.
With some skill and foresight, derivatives will allow you to effectively hedge against any price fluctuations. While they may still be in their infancy, derivatives are sure to make their impact felt in the years to come.
Just like sports betting, investing in cryptocurrency can be a risky proposition for the unprepared. However, with some preparation, you should have no issue riding out the storm and betting on a winning horse.
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