Hedging. Protection methods for trade capital.

Previously, we talked about how to properly build an investment portfolio and to consider diversifying risks in order to get good profits and to keep high security of their assets. However, diversification is more related to financial management, i.e. how exactly to manage assets within a portfolio. It’s not so much responsible for its safety as for the correct distribution of assets. In order to secure your investment portfolio, you need to resort to risk hedging, which is what we will talk about in this article. Here we will tell you what hedging is and with what financial instruments it is done.

Definition

Hedge is an effective mechanism to insure price risks, in order to avoid losses if the price of an asset or commodity starts to move in the worst direction. The role of risk insurance is assumed by the so-called contract or “hedge”, and the one who hedges financial risks is called a “hedger”.

There are two types of hedging:

  1. For a promotion. If a market participant needs to protect himself from an expected increase in the price of an asset in the future, a contract for the delivery of this asset at the previously agreed amount is bought.
  2. Decreasing. If a market participant intends to sell the asset at the price it needs after a certain period of time, the contract to sell the asset at a pre-agreed price is bought.

A hedging strategy is implemented using derivatives — derivatives, which in our case are called “hedges”. Let’s take a closer look at each derivative and how it can be used to hedge risks.

Hedging instruments

Futures

Futures — is a contract to buy or to sell a certain asset in the future. The price and quantity are negotiated in advance to avoid possible losses due to price changes. Such losses in case of using futures contracts cannot be received, it’s possible to make a profit.

Futures contracts are divided into two types:

  1. The delivery future obliges the seller to deliver the bitcoins to the buyer at the price, specified in the contract at a strictly defined time. For example, in July you bought a September delivery futures for 1 BTC at $10,000. Regardless of whether the price of the bitcoin drops or rises, the seller transfers 1 BTC to you in September.
  2. The settlement futures works under the similar scheme with the only difference that the calculation takes place in money, without delivery of the underlying asset to the buyer. For example, in July you bought a September futures for 1 BTC at $10,000. If the Bitcoin went up in price by $500, you will get $10,500 back in September. If the bitcoin has fallen in price by $500, you will get $9500 back in September.

Example of using a delivery futures to hedge risks, note that there are two options for hedging with futures — a short and a long hedge:

Option 1- “Short Hedge.”

The investor bought Bitcoin for $10,000, expecting it to grow in 2020 against the backdrop of the past halving. However, by September the price of Bitcoin may start to fall due to concerns about a second wave of the pandemic. To avoid a potential loss of 20%, an investor may use a delivery futures and then sell the bitcoin in September at $10,000. In case the value of the bitcoin starts to fall, the investor sells his bitcoins at a fixed price and avoids any loss.

Option 2- “Long Hedge.”

The investor plans to buy Bitcoin in September for $10,000, expecting its growth in 2020 against the backdrop of the past halving. However, until September, the price of Bitcoin may rise and deprive the investor of potential profit. In order to guarantee the price of $10,000 per BTC, an investor can use a buy futures delivery in September at a price of $10,000. In case the value of the bitcoin starts to grow, the investor will buy a BTC at a fixed price of $10,000.

Options

Options- is a contract for the right to buy or sell an asset in the future. When concluding an option, a premium is paid as the owner of the option may not be able to use his right.

Options are divided into two types:

1. Call option — the right to buy an asset at a specific price.

2. Put option — right to sell the asset at a certain price.

An example of using a put option to hedge risks:

Investor purchased 10 BTCs at a price of $10,000. There are growing concerns in the market about a second wave of coronavirus pandemic, which could bring the cost of Bitcoin to $5000. Investor buys put option, which gives him the right to sell bitcoin in 2 months at the same price of $10,000. The cost of the option (premium) is $500.

In case Bitcoin falls to $5000, the investor can use his right to sell Bitcoins at $10,000. In this case, he will lose only $500 of the option premium, but will save 50% of his capital. In addition, by selling a BTC for $10,000, he can buy twice as many BTCs for $5,000 at any time, which will bring him much more profit when the price starts recovering.

In case Bitcoin doesn’t fall, the investor may waive the right to sell and lose $500.

In case Bitcoin has risen, for example, up to $10,100, the investor also waives the right to sell and loses $500 for buying the option, but a $100 rise in the value of the BTC brought him $1,000 in profit or $500 in profit, minus the cost of the option.

An example of using a call option to hedge risks:

An investor plans to buy 10 BTCs at $10,000. There are growing concerns in the market about a second wave of coronavirus pandemic, which could bring the cost of Bitcoin to $5000. Investor buys call option, which gives him the right to buy 10 BTC in 2 months at a price of $5,000. The cost of the option (premium) is $500.

In case the bitcoin falls to $5000, the investor can use his right to buy bitcoins at $5,000. In this case, he will lose only $500 of the option premium, but will save 50% of the capital he could have spent on buying for $10,000.

In case the bitcoin didn’t fall or grew, the investor may waive the right to buy and lose $500.

Conclusion

As you can see, you can use derivatives not only for trading open-ended leveraged contracts and risking capital, but also for hedging risks in instruments such as futures and options. The main problem of a trader is the lack of ability to know 100% where the price will go, no matter how first-class analyst a trader is. Hedging price risks allows to exclude losses in case of sharp changes of the market situation. In some cases, hedging brings profit as well, so you shouldn’t ignore this instrument.

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