How Crypto Traders Use Derivatives to Hedge Risk | Chaintalk

How Crypto Traders Use Derivatives to Hedge Risk

ChainTalk

bitcoin derivatives

Every bitcoin trader knows that you can’t put all your eggs in one basket. It is a rule of thumb that many of you have learned from the beginning. Despite this knowledge, it is often very difficult for traders to spread the risk. What then can be done to protect yourself in an industry as volatile as the crypto market? Many traders turn to bitcoin derivatives for risk management.

A derivative is a financial contract between two parties that derives its value from the future performance of an underlying asset.

Derivatives have been in the financial world long before cryptocurrencies were known to humans. Derivatives are some of the oldest financial instruments in existence. Their history goes a long way back and they have evolved over the course of time.

Why turn to derivatives

There are many areas where derivatives are used but their main purpose is hedging as investors try to save themselves from the negative effects of price fluctuations. In such a scenario, it helps to sign a contract that specifies the price which you will buy or sell a financial product in the future.

You should note that hedging is mainly used as a method of preventing future losses against volatility rather than as a profit-making mechanism. Hedging is mainly about ensuring stability in your investment portfolio.

How crypto traders use derivatives for hedging

The crypto market is known for its volatility. Prices can go up and down at any moment without notice. Some traders have lost money by not timing the market very well. A number of traders are turning to derivatives to hedge against risk. These are some of the ways in which it is done:

Hedging using CFDs

Traders are able to hedge their cryptocurrencies through contract-for-difference or CFD trading. CFDs are derivative products that allow you to speculate on price movements without having to own the underlying asset.

What this means is that you can profit from both a bull or bear crypto market without having to purchase any crypto assets. In the world of cryptocurrencies, this works in your favor in several ways such as:

  • You do not have to worry about the security of your private keys – you may already know by now that owning bitcoin basically comes down to owning the private keys to your cryptocurrency wallet. The only way to keep your cryptocurrency safe is through keeping your private keys safe, which for some people is not an easy thing to do.
  • Hacks – many traders keep cryptocurrencies they want to trade on exchanges and trading platforms. History has shown that these marketplaces are susceptible to attacks from hackers. Exchanges have already lost more than $1 billion through online theft. CFDs allow you to trade digital assets without having to worry about their security because you do not need to own them (digital assets).

Unlike owning digital assets, owning CFDs allows you to benefit from market movement irrespective of the direction it is taking. If you think the price of a cryptocurrency is low, you can buy a CFD and benefit from the price appreciation. This is called going long. You can also sell a CFD when you anticipate the price of a digital asset to decrease in the future. It’s called shorting.

Hedging using derivatives

Derivatives are widely used as a hedging mechanism in stock trading. The most common derivatives include futures, forwards, swaps, options, and more. Bitcoin derivatives trading platform Overbit has a great article called “Bitcoin Derivatives Explained for Traders“. Some of the well-known underlying assets used in derivatives trading include stocks, bonds, indexes, commodities, interest rates, and currencies.

In the crypto market, the development of derivatives is still in its early stages but the silver lining is that more trading platforms offer a suite of derivative products in the market.

A futures contract is a contract that allows you to buy or sell an asset for a specified price in the future.

In the crypto sector, futures are used by miners to have a guarantee on the price of bitcoin at a future date. Bitcoin mining is a very expensive process that consumes a lot of electricity. The capital required to set up mining farms is very high, yet the digital asset itself is very volatile.

For miners, this is a double-edged sword because, in the future, the price of bitcoin may significantly drop and expose them to losses. By signing derivative contracts, the miners are assured that the bitcoins they mine will be sold for a particular price.

While this may reduce their potential of making more money in the future if the price of bitcoin appreciates, the benefits of hedging outweighs the potential of making more in the future.

The same can be said for bitcoin traders. Derivatives can mitigate the risk of selling their digital assets at a lower price in the future.

Manage your risk

Although short selling and derivatives trading are used in hedging against risk, they are now used for speculation purposes. However, these hedging techniques are highly advanced and require experienced traders to use them. The risk of derivatives is theoretically unlimited. You should not use them for speculation.

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