What is Hedging?

Hedging is a trading strategy that involves taking opposite positions in derivative markets (such as futures or options) to reduce price volatility risk in spot markets. When asset prices become uncertain, derivatives are used to convert potential price fluctuations into manageable risks, thereby protecting asset value. This approach helps investors and businesses minimize potential losses from market volatility and maintain financial stability.

This risk management tool is widely used across financial, energy, and commodity sectors. When faced with inevitable market price changes in commodities, stock indices, or currencies, businesses can use hedging to lock in future costs or revenue, reducing financial uncertainty. For investors, this strategy helps optimize portfolio risk management and supports long-term stable asset growth.

Why Use Hedging?

In cryptocurrency markets, hedging is a widely adopted risk management technique that helps investors minimize potential losses from extreme market volatility. Due to the highly volatile nature of crypto markets, both individuals and institutions face risks from rapid price changes. Similar to traditional financial markets, the crypto sector uses derivatives like futures and options to lock in prices and hedge risks, effectively protecting spot assets from adverse price movements.

Compared to traditional markets, cryptocurrency markets show significantly higher volatility, with some assets experiencing double-digit price swings within a single day. Market sentiment plays a crucial role in crypto asset price movements, with major cryptocurrencies like Bitcoin and Ethereum being driven by policy changes, significant news, and technological innovations. To protect against substantial portfolio losses from these price fluctuations, many investors and institutions implement hedging strategies.

The primary goal of hedging is to reduce how market uncertainty affects asset value. Large institutional investors are particularly focused on protecting against potential losses from significant price drops. By taking opposite positions in derivatives markets, investors can use potential gains in derivatives to offset losses in spot markets, achieving stable portfolio performance.

Hedging Methods in Cryptocurrency Markets

There are various hedging methods available in crypto markets, primarily using derivative instruments like futures, options, and perpetual contracts. Each strategy serves different scenarios and has unique implementation approaches. The fundamental goal of hedging is to offset price volatility risk by establishing opposite positions in derivative markets compared to spot holdings. Let’s explore these common hedging techniques.

Futures Contracts

Futures contracts are widely used risk management tools in cryptocurrency markets. They allow investors to agree on a price to buy or sell an asset at a future date. This mechanism helps investors lock in prices and reduce risks from market volatility.

Long futures to hedge short spot positions: When investors hold a short bitcoin position and expect prices to rise, they can buy futures contracts to reduce risk. If bitcoin prices increase, losses in the spot position can be partially or fully offset by profits from futures contracts.

Short futures to hedge long spot positions: For investors holding long bitcoin positions who are concerned about price drops, selling futures contracts can hedge this risk. When bitcoin prices fall, although spot asset value decreases, profits from futures contracts can effectively minimize losses.

Options Contracts

Options contracts are another common hedging tool. Unlike futures, options give holders the right, but not the obligation, to buy or sell assets at specific prices and times, providing greater flexibility for investors.

Buying put options to hedge long spot positions: Investors holding cryptocurrency who worry about price drops can buy put options to hedge downside risk. When crypto prices fall, the option’s value increases, offsetting spot market losses.

Buying call options to hedge short spot positions: Investors with short positions concerned about price increases can buy call options to hedge upside risk. If market prices rise, gains in options contracts can offset losses in short positions.

Perpetual Contracts

Perpetual contracts are unique derivatives in cryptocurrency markets that track spot market prices without expiration dates. They are ideal for short—to medium-term hedging.

Selling perpetual contracts to hedge long positions: Investors holding long Bitcoin positions can sell perpetual contracts to protect against price drops. If Bitcoin prices fall, losses in the spot market are offset by gains from perpetual contracts.

Buying perpetual contracts to hedge short positions: Investors with short positions can buy perpetual contracts to protect against price increases. When prices rise, gains from perpetual contracts compensate for spot market losses.

Case Study: Hedging During the Luna Crash

The collapse of Luna (Terra) and its stablecoin TerraUSD (UST) was a major black swan event in the crypto market, resulting in billions of dollars in losses. Many investors suffered significant losses due to inadequate risk management strategies.

Using Futures Contracts for Hedging

Futures contracts are common hedging tools in crypto markets. Investors can hedge against price drops by taking short positions in futures contracts. For instance, when Luna’s price was high, investors could open short futures positions matching their spot holdings. When Luna’s price crashed, gains from the short positions helped offset spot market losses.

Example: An investor holding $100,000 worth of Luna could sell an equivalent amount of Luna futures when the price was $100. When Luna dropped to $10, the spot position value fell to $10,000, but the short futures position gained approximately $90,000 (after fees). This hedging strategy helped maintain the total portfolio value.

This approach works best for investors who can quickly act when negative market signals appear, effectively protecting against significant price drops.

Using Options for Hedging

Options are flexible derivative instruments ideal for investors who want to protect assets while maintaining upside potential. During the Luna crash, investors could use put options to set a minimum selling price for their assets, providing protection during market crashes.

Example: An investor holding 1,000 Luna (at $100 each) pays $5,000 for put options with a $90 strike price. When Luna crashed to $10, the investor could exercise the options to sell at $90, securing $90,000. Even after deducting the $5,000 premium, this strategy prevented major losses.

Through options trading, investors can participate in market upside while effectively limiting downside risk during crashes.

Adjusting Liquidity Mining Strategy

The algorithmic stablecoin UST in the Luna ecosystem offered liquidity mining opportunities. However, when UST lost its dollar peg, the risks associated with liquidity mining increased significantly. Before the crash, investors could choose to exit high-risk liquidity pools early and move assets to lower-risk stablecoins.

Example: As UST’s price fell from $1 to $0.80, some investors reduced liquidation risks by buying UST at a discount in the secondary market to repay loans. Additionally, experienced investors timely exited Luna/UST liquidity mining pools, transferring assets to stable alternatives like USDC or DAI, avoiding the catastrophic drop when UST later crashed to $0.10.

This strategy works best for investors who are sensitive to market signals and can quickly adjust their positions.

Combining Spot Leverage and Perpetual Contracts

Investors can implement flexible hedging strategies using perpetual contracts and spot leverage trading. During extreme market volatility, spot holders can open short positions in perpetual contracts to hedge against downside risk while using leverage to amplify returns or adjust risk exposure.

Example: An investor holding $10,000 worth of Luna opened a 2x leveraged short position in perpetual contracts. When Luna’s price dropped by 50%, the spot position value fell to $5,000, but the perpetual short position generated $5,000 in profits, effectively hedging the loss.

This method is suitable for markets with high short-term volatility and requires investors to adjust leverage ratios according to their risk profile to achieve optimal results.

Moving Assets to Lower-Risk Instruments

A direct way to protect capital before black swan events is converting high-risk assets (like Luna or UST) to lower-risk assets (such as USDC or BTC). When market sentiment turns negative, investors should decisively move to more stable assets to avoid high volatility risks.

Example: During the early stages of the Luna crash, when UST dropped from $1 to $0.98, some investors quickly converted their UST to USDC, avoiding the subsequent complete collapse. This strategy helped preserve capital during extreme market conditions.

This approach works best for investors who can anticipate market risks, especially when market signals clearly indicate deterioration.

Costs of Hedging

Direct Financial Costs

Direct financial costs include trading fees, funding rates, and option premiums. For example, futures contracts require opening and closing fees, while perpetual contracts accumulate funding rate costs over time. Option premiums paid for downside protection become sunk costs if the market remains stable. Price slippage in low-liquidity or volatile markets can also increase hedging costs by causing trades to execute at unfavorable prices.

Rate (I) = (Quote Rate Index - Base Rate Index) / Funding Rate Interval

Where:

Base Rate Index = Lending rate of base currency

Quote Rate Index = Lending rate of quote currency

Funding Rate Interval = 3 (as funding occurs every 8 hours)

Opportunity Costs

Hedging can limit profit potential. When prices rise, losses on short positions offset spot gains. Additionally, strategies that lock up capital as margin reduce flexibility to participate in other opportunities, such as DeFi yield farming or other investment projects.

Hidden Costs

Hidden costs involve time, effort, and risk management complexity. Crypto market volatility requires constant monitoring and position adjustment, which consume resources and potentially introduce new risks. Leveraged futures positions might be liquidated during short-term rebounds, amplifying losses. Incomplete hedging or improper tool selection can also lead to inadequate risk coverage.

Advantages of Hedging

Risk Exposure Reduction

Cryptocurrency markets are highly volatile, especially during market turbulence, macroeconomic changes, or black swan events (like Luna and FTX incidents). Through hedging, investors can offset spot market losses with profits from derivatives like futures and options contracts. This risk-hedging approach helps maintain asset stability in uncertain market conditions.

Profit Protection

For investors with existing profits in the crypto market, hedging provides a way to secure gains. By linking assets to derivative contracts (such as selling futures or buying put options), investors can protect their profits even during market reversals. For example, when an investor profits from Bitcoin’s price increase, they can protect these gains against sudden market corrections by selling futures contracts.

Market Flexibility

Hedging protects existing assets and increases flexibility in uncertain markets. Given the rapid changes in crypto markets, investors can adjust their hedging strategies (such as modifying futures positions or adjusting option strike prices) to adapt to real-time market conditions. This flexibility allows better risk control amid market volatility.

Single Asset Exposure Protection

Many crypto investors concentrate their funds in single assets (like Bitcoin or Ethereum), exposing them to significant market risk. Hedging helps investors diversify this risk through derivative instruments. For instance, investors can hedge against potential price drops by buying futures contracts related to their target asset, reducing single-market exposure risk.

Disadvantages of Hedging

Fees and Costs

While hedging helps protect against market volatility, it comes with additional costs. Futures and options trading involve transaction fees, holding costs, and option premiums, which can reduce profit margins. Option contracts lose time value as they approach expiration, meaning even correctly chosen hedging strategies can result in partial value loss.

Limited Potential Returns

Hedging can cap potential profits. When using futures contracts to hedge, upward market movements may result in futures losses offsetting spot gains. This protection mechanism, while safeguarding capital, can limit upside potential, especially during bull markets.

Complexity and Technical Requirements

Crypto derivatives are complex and highly specialized. Successful hedging requires deep understanding of markets and instruments, including futures and options structures, leverage, and expiration dates. The technical barriers can be high, and inexperienced traders risk making costly mistakes.

Market Liquidity Risk

While derivatives markets generally offer good liquidity, crypto derivative contracts may face liquidity issues, especially during market turbulence. In extreme cases, insufficient liquidity can make it difficult to close positions or execute hedging strategies. This can also lead to wider spreads, increasing trading costs.

Risk Management Failures

Hedging isn’t foolproof. Poor strategy choices, market misjudgments, or excessive leverage can amplify losses. In the fast-moving crypto market, where price swings are dramatic and quick reactions are crucial, risk management failures can have severe financial consequences.

Conclusion

In summary, hedging is a crucial risk management tool in cryptocurrency markets. Through proper use of derivatives, investors can minimize losses during market volatility, protect assets, and maintain flexibility during market reversals. While hedging offers many advantages, it comes with drawbacks including trading costs, limited potential returns, technical complexity, and market liquidity risks. Therefore, investors should carefully evaluate market conditions, trading costs, and their risk tolerance when implementing hedging strategies to achieve balanced risk management.