Crypto risk management – part 3: hedging

In part 1 and part 2 of this series I covered some basic concepts about risk management and trading in general. In this part, I’m going to explain how these concepts can be used for hedging against price volatility. It’s important to note that we are not talking about active trading techniques here, this is about risk management.

Before reading further, please note that none of what I’m covering should be considered investment advice. In fact, you should definitely not put any money into crypto without having done an awful lot of research on your own.

Unit of account

Before you decide on any risk management strategy, you must decide what your personal unit of account is. How do you account for your holdings? If you do accounting completely in BTC, then its USD price pairing doesn’t matter at all. The more BTC you hold the better because the price against itself isn’t volatile. However, if you account for your portfolio in USD, then what you need to hedge against is the BTC/USD price.

For long-term believers in crypto it’s common to account your different holdings in BTC. For example, if you account your ETH holdings in BTC, you must hedge against the ETH/BTC price volatility. This might not be as useful for the common person who’s life is mostly accounted for in fiat currency like USD.

In this blog post I will assume that the unit of account is USD.

Long vs. short

If you are interested in the technology around blockchains like Bitcoin or Ethereum and have bought some of these assets, then you are long in that position. One can say that you have 1x leverage on that long position and your holdings increase in value as the price goes up.

One can also have a short position on an asset. I won’t go into more detail here, since I explained how this works earlier in part 2.

Increasing vs. decreasing leverage

Margin trading is most commonly known as a tool to increase the leverage on either a long or short position in order to increase risk (and potential reward). But trading on margin can also be used to decrease the leverage of a position in order to decrease risk (but also decrease potential reward).

If all you have is a long position on an asset with 1x leverage, then you are betting your entire investment on the value to increase. So if the asset increase 20% in value, you are exposed to 100% of that increase. But you are also 100% exposed if the value decrease by 20%. For assets that are highly volatile this becomes problematic if you want to handle your investment responsibly.

By decreasing the leverage of your portfolio, to let’s say 0.5x, you will only see half of the profit compared to the the price increase, but you will also only lose half as much when the price declines. I will get to how one can achieve this in a bit.

Example

Let’s imagine Eve, she wants to invests $1000 in Bitcoin assets. After she invests, the price will first increase by 25%. But later the market sentiment will crumble as there are some bad news, followed by a price decline of 60%.

Now, Eve have largely three different ways to manage her portfolio and its risk.

Scenario A: No hedging, just holding

Eve can choose to just store and hold her Bitcoin assets in a safe hardware wallet offline so that the Bitcoin itself is totally secure.
After the scenario played out, her investment is down -50% with a total holding of $500.

Scenario B: Hedging by selling

Eve wants the ability to hedge against a price decline, by keeping some of her Bitcoin easily available on an exchange so that she can sell them. However, she decides to only keep 50% on the exchange since she’s not willing to take more custodian risk.

After the initial price increase of 25%, her investment will be worth $1250 ($1000 * 1.25). When Eve reads about the bad news she’ll sell the funds on the exchange to partially hedge against the decline. She has effectively deleveraged her holdings to 0.5x and will only lose half as much value during the decline.
After the scenario played out, her investment is -12.5% with a total holding of $875 ($250 of Bitcoin and $625 of cash).

In this scenario, Eve has only been able to hedge half her position, and she must keep as much as 50% of her Bitcoin on the exchange. This results in a large custodian risk, with poor returns.

Scenario C: Hedging by shorting

In this last scenario Eve will further reduce the risk of both custodianship and volatility by using short selling to hedge.

At the beginning, instead going all-in with her investment she will buy Bitcoin for $800 and keep $200 in cash on the exchange that she can short with, as a hedge against volatility.

After the initial price increase of 25%, her investment will be worth $1200 ($800 * 1.25 = $1000 of Bitcoin, and $200 of cash). When Eve reads about the bad news she’ll use the $200 cash on the exchange and open a short position with 5x leverage to cover the value of the Bitcoin that she’s got in secure cold storage. While her hedge is open she has effectively deleveraged her holdings completely. When the value of the Bitcoin decrease by 60%, her short position will profit with the same amount.
After the scenario played out, her investment is +20% with a total holding of $1200 ($400 of Bitcoin and $800 of cash).

In this scenario, Eve has been able to hedge her entire position, and she can also keep much less of her investment on the exchange. In fact, she only needs to keep cash there as collateral for the hedge, and no Bitcoin. The custody risk is much lower in this case.

Conclusion

After assessing these different scenarios, one can quite easily argue that the third scenario carry a lot less risk, both in terms of investment but also in terms of custody risk with an exchange. To rank the scenarios in order of risk taking, I would say (1) just holding (2) hedging by selling (3) hedging by shorting.

The key take-aways with this post is that (a) margin trading can be used to deleverage your holdings in order to manage risk, and (b) one must be very comfortable with using USD (or other fiat) as unit of account when holding a hedge in volatile conditions.

4 thoughts on “Crypto risk management – part 3: hedging

  1. Hi Dick, Thanks for the great article. If I wanted to secure the purchase of any crypto at a specific price in the future, what would be the best strategy e.g. I have $1000 now and i want to buy Steem for $3.50 in 6 months time, assuming today’s price is $3.50.

    How would i do this practically with today’s illiquid markets? Also assume large volumes e.g. not $1000 but $100m … look forward to your response.

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