Financial investments often come with the potential for substantial profit, but they also carry significant risks. Many investors tend to ignore safety rules in pursuit of huge returns. Here, at the itez team, we’d like to remind you that this is not the best approach.
In our new comprehensive guide, you’ll learn what is hedging, its pros and cons, and how to start minimising risks through this strategy.
Introduction to hedging
Definition of hedging
First, let's define hedging. Simply put, hedging is a specific method used to protect investors from financial risks. Primarily, hedging helps combat market volatility by minimising potential losses due to asset price fluctuations.
If you're still unsure what is hedging, it's essential to understand that it’s a comprehensive investment strategy that involves a variety of tools and techniques. In simpler terms, it’s like insurance for your investment portfolio: you pay for protection to minimise possible losses.
The purpose of hedging in finance
As mentioned earlier, the main goal of hedging is risk mitigation and safeguarding capital from adverse market movements. Unlike speculative trading, with traders aiming to profit from short-term price fluctuations in cryptocurrencies, hedging is designed for the opposite purpose. In short, the primary objective is not to make a profit but to avoid losses.
How hedging works
Basic principles of hedging
Since the goal of “minimising losses” can vary greatly depending on the scenario, hedging itself can work in different ways. Therefore, it's crucial to clarify several key aspects beforehand. Here are the questions every investor or trader should ask before taking action:
1. What specific risks do I need to insure?
2. Which financial tools are best suited to achieve my goals?
3. Which protective strategies will work best in my case?
Once these questions are answered, you can formulate a well-defined investment strategy to ensure capital protection.
‼️ This article is for educational purposes only. The itez team does not recommend using this strategy in practice. Readers are responsible for any investment decisions made based on this material.
Types of risks hedging can mitigate
Hedging helps manage various types of risks. These can include: market risks (the risk of losses due to fluctuations in asset prices), interest rate risks (the risk of losses due to changes in interest rates), or credit risk (the risk of losses from counterparty defaults).
Here are some of the most common risks that traders and investors face in the cryptocurrency market:
- Volatility. The prices of digital assets can fluctuate significantly within very short periods. Sometimes these swings lead to profit, and sometimes to losses. Using certain financial instruments can help minimise the risks associated with volatility. We'll discuss these tools in more detail later.
- Liquidity. On some cryptocurrency exchanges, or during periods of high volatility, there may be insufficient liquidity, making it difficult to sell assets at the desired price or in the required volumes. Hedging can include strategies using derivatives to offset losses when assets cannot be sold in time.
- Currency risks. Cryptocurrencies are traded in various pairs with fiat currencies or other cryptocurrencies. Changes in the exchange rate of one currency relative to another can lead to losses.
- Counterparty risk. In the crypto market, there’s also a high risk of credit issues, as trading platforms can be unreliable, subject to hacks, fraud, or even scamming their clients.
- Regulatory risk. The digital asset market is not yet fully integrated into the modern legal framework. Therefore, the regulatory landscape of the industry can change at any time, potentially exposing investors to restrictions on cryptocurrency trading, tightened regulations, or tax changes.
Common hedging instruments
We've now covered the typical risks, but how can you protect yourself from them? Specifically designed to combat each of these risks, investors have financial derivatives in their arsenal. This term refers to financial contracts whose value depends on the price fluctuations of an underlying asset—whether that be stocks, commodities, currencies, or any other financial instruments.
Let's break down how each of these derivatives works:
1. Futures contracts are standardised agreements to buy or sell an asset for a future date, acting as insurance against unfavourable market conditions. In other words, both parties are obligated to fulfil the terms of the contract upon its expiration. Futures allow the price of an asset to be locked in, thereby protecting against unfavourable market changes.
2. Options differ from futures in that they provide the right (but not the obligation!) to buy or sell an asset at a predetermined price before a specified date. This makes options a more flexible tool compared to futures. Options can be used to protect against unfavourable changes in asset prices.
3. Forward contracts are very similar to futures in essence. The main difference is that such contracts are traded privately between the parties rather than on exchanges. This makes forward contracts a more flexible and tailored tool compared to futures contracts. They allow the price of an asset to be fixed and help manage the risks associated with its future value.
4. Swaps are agreements for the exchange of financial flows (i.e. payments or assets) between parties. The most common types are interest rate and currency swaps.
Hedging strategies
Now, let's explore the most popular strategies that traders and investors use in cryptocurrency markets for asset protection.
The first of these is portfolio diversification. This strategy involves spreading investments across various assets (or even asset classes such as cryptocurrencies, currencies, bonds, and so on), which helps to reduce risks. The idea is that if one investment becomes unprofitable, the stability or profitability of other assets can balance out the overall financial picture.
For example, if Bitcoin falls, the rise of altcoins might offset the losses. With a well-diversified portfolio, an investor can avoid significant losses even if one of the assets they’ve invested in drops to zero.
The next strategy is protective puts and calls. This involves using options, which we discussed earlier. These types of derivatives protect investors from unexpected declines or rises in asset value. Here’s the difference between the two types:
- Protective puts. Buying a put option gives the right to sell cryptocurrency at a predetermined price, protecting against a drop in its value.
- Protective calls. Buying a call option provides the right to purchase cryptocurrency at a fixed price, ensuring protection from missed opportunities if the asset’s price rises. This can help lock in potential profits.
Another widespread strategy is known as currency hedging. As the name suggests, this technique is used by investors to protect against currency fluctuations. If an investor is dealing with cryptocurrency across different fiat currencies (for example, buying Bitcoin in dollars and selling it in euros), they face risks related to exchange rate changes. In such cases, financial derivatives like futures contracts or Options come to the rescue, allowing investors to fix the exchange rate in advance and minimise the risks of losses from currency fluctuations.
The final strategy on our list is commodity hedging. This is used to protect against changes in commodity prices. For example, companies involved in mining can hedge the risk of price changes for electricity or equipment by using derivatives on commodities (such as oil or gas futures).
Real-world examples of hedging
Hedging strategies and techniques are by no means limited to cryptocurrency investing—they have long found their application across various financial markets.
1. Hedging in the stock market. In the stock market, investors can use options and futures to protect their shares from price drops. This helps minimise losses during market downturns.
2. Hedging in the forex market. In the foreign exchange market, companies can utilise forward contracts and currency swaps to shield themselves from fluctuations in exchange rates. This enables them to lock in prices and avoid losses tied to exchange rate changes.
3. Hedging in the commodities market. In commodity markets, farmers and producers use futures contracts to guard against price fluctuations in raw materials. This allows them to fix future prices and manage risk effectively.
Benefits and risks of hedging
To summarise, let’s now look at the key advantages and disadvantages of hedging.
Advantages of hedging
👍 Capital protection. The primary goal of hedging is to minimise potential risks for investors. Hedging helps protect investments from sharp price fluctuations, which can be significant in the cryptocurrency market.
👍 Reduction of volatility. Hedging can help stabilise returns and reduce the volatility of an investment portfolio.
👍 Flexibility of instruments. Hedging provides the ability to protect against various types of risks in different market conditions. The use of different financial derivatives (futures, Options, swaps, and forward contracts) allows investors to choose strategies suitable for different market scenarios.
👍 Profit locking. Investors can lock in profits or minimise losses using futures contracts and Options.
Potential drawbacks and limitations
👎 Additional costs. Hedging involves extra costs (such as premiums for options or commissions for futures), which can reduce overall profits.
👎 Limitation of profits. In some cases, hedging protects against losses but also limits potential gains from price increases.
👎 Need for expertise. Effective hedging requires knowledge and experience with complex instruments like derivatives, which can be challenging for beginner investors.
👎 Counterparty risk. In the cryptocurrency market, not all contracts are traded on regulated exchanges, so there is a risk of unreliable counterparties (especially when using forward contracts).
Comparing hedging with speculative trading
Earlier, we highlighted that the techniques and the essence of hedging are directly opposed to another popular strategy — speculative trading.
Hedging focuses on asset protection and risk mitigation, making it an ideal strategy for long-term investors or companies. While it reduces potential losses, it also limits possible profits. On the other hand, speculative trading aims for maximum profit in a short period, but it comes with higher risks of loss. This strategy suits more aggressive traders who are willing to take on greater risks in pursuit of significant gains.
The choice between these two strategies depends on the investor's goals: whether they prioritise risk management and stability, or are aiming for quick profits while accepting higher risks. For your convenience, we've summarised the key pros and cons of hedging and speculation in the table below.
Frequently Asked Questions (FAQ)
What is hedging? Hedging is a method used by investors to protect themselves from financial risks, primarily by reducing the impact of market volatility and preventing potential losses.
How does hedging work? Hedging works by using financial instruments, such as futures, options, and swaps, to lock in prices or minimise the risks of asset price fluctuations, ensuring capital protection.
What are the benefits of hedging? Hedging protects capital, reduces volatility, provides flexibility through various financial instruments, and helps lock in profits or limit losses.
What are common hedging strategies? Common strategies include portfolio diversification, protective puts and calls, currency hedging, and commodity hedging, each tailored to mitigate different types of risks.
Conclusion
In short, hedging is a strategy that helps protect investments from risks like market volatility and price changes. It acts as insurance to minimise potential losses.
The key benefits of hedging are capital protection, reduced volatility, flexibility in financial tools, and the ability to lock in profits. However, it also has downsides, such as added costs, limited profit potential, and the need for expertise.
This article is for educational purposes only. The itez team does not recommend using this strategy in practice. Readers are responsible for any investment decisions made based on this material.
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This article is not investment advice or a recommendation to purchase any specific product or service. The financial transactions mentioned in the article are not a guide to action. It’s not intended to constitute a comprehensive statement of all possible risks. You should independently conduct an analysis on the basis of which it will be possible to draw conclusions and make decisions about making any operations with cryptocurrency.
