How to use Crypto Futures to Hedge your Bitcoin & Crypto Holdings?

Introduction

Before we start with the main topic, let us do a little recap of what Futures contracts actually are. According to official definitions, a futures contract is an agreement to buy or sell a particular asset, security, or commodity at a predetermined price at a specified time in the future. 

So as a concept, the buyer of a futures contract in the deal has an obligation at the end of a period to buy and receive the underlying asset when the futures contract expires. Similarly, the seller of a futures contract has the obligation to provide and deliver the underlying asset on the day of expiry. Thus it is effectively a financial derivatives contract because it is a deal that is derived from an actual asset and does not immediately result in an exchange of the asset between the two parties. 

So, before the idea of trading came into the picture, Futures as a concept was born primarily as a hedging tool. Let us take an example to explain the same. A commodity trader back in the day had to purchase inventory at a certain price and then had to sell it further in the open market at a slightly higher price to make a profit. However, there are certain times, when the market value of the commodity under consideration falls so much after a trader bought it, that he or she cannot sell it at a profit. This is where futures contracts come into the picture.

This trader can go short on the commodity in the futures market while actually buying up the actual commodity for their inventory. Now say the price goes up, all the trader has to do is sell it at a profit that covers the loss incurred on the short position. On the other hand, if the market value of the commodity goes down, the value of the trader’s inventory will go down, but the trader will profit off of the short position in the futures market. This is how a commodity trader can hedge their downside risk using futures.

So where do futures crypto contracts come in?

So crypto futures work in a similar way, with one key difference. In the world of crypto futures, you have the additional benefit of having the feature of perpetual futures contracts. These are futures contracts that have the same features as a traditional futures contract, but without the expiration date, as the name suggests.

To know more, read:  Perpetual vs Traditional Futures

How can I use crypto futures contracts to hedge my crypto portfolio?

Similar to the example mentioned earlier, a crypto futures contract can be used to mitigate the risk of falling prices of their actual holding portfolio, if there is a valid futures market for that particular crypto asset. If it is some relatively newer crypto asset from a project, chances are that you might not have a futures contract to hedge against it.

However, if you are creating a portfolio of the major, well-known coins, there is a high probability that you will find a crypto futures exchange that offers the necessary trading pair for you to use.  Let us take an example from the crypto point of view. Suppose a crypto investor holds 1 BTC worth around $25,000 and wishes to protect the investment. To do that, the investor will create a short position in the BTC futures market at $25,000, using an amount of leverage that he or she is comfortable with. 

Now from the current situation, if the market goes down, the investor’s long position on the spot Bitcoin will be in a loss but the short position will result in a handsome profit, thanks to the leverage. Now, if the investor is very bullish on the crypto asset, he or she can double down on their BTC investment by buying up more with the extra cash he gained out of the short futures trade, in anticipation that when the market reverses, he will have a better holding.

On the other hand, if the market goes up from the $25,000 mark, the spot position of BTC would be in profit but the futures position would be in a loss and the investor would need to find an opportunity to exit that short futures position at the least loss possible. 

This is how a crypto investor can use crypto futures to their advantage in hedging their own portfolio of crypto assets. 

However, one thing to note is that if investors take up a higher amount of leverage, there is a chance that their short-term profits may get a huge boost. But on the flip side, if the market continues to go against them, losses will be higher as well. Thus a very careful and strategic implementation of a hedging strategy is extremely important to ensure that this exercise is a profitable one. Therefore, crypto investors need to be very cautious of the risks that using leverage poses when operating in the futures market. 

Read more: Guide to CoinDCX crypto futures app

Conclusion

So to put forth a concluding thought, crypto futures is something that you can use even if you’re not an active trader but only an investor. Derivative products like futures and options are increasingly being used for speculative purposes but it is not necessary that everybody has to do it. Using futures derivatives to protect your investment portfolio downside is a great way to be an active investor in the crypto market and be able to withstand the bad times and market volatility! 

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