Hedging cryptocurrency with futures is a strategy used to protect against the risk of adverse price movements in your crypto holdings. Since cryptocurrencies like Bitcoin and Ethereum are highly volatile, futures contracts can help you lock in a price and reduce potential losses. Below is a clear, step-by-step explanation of how to do it.
What Does Hedging with Futures Mean?
Hedging involves taking a position in a financial instrument (in this case, futures) to offset potential losses in another asset (your cryptocurrency). Futures are contracts that obligate you to buy or sell an asset at a set price on a future date. By using futures, you can counteract price drops in your crypto holdings with gains in the futures market.
For example, if you own cryptocurrency and fear its price might fall, you can use futures to “insure” your position. Here’s how it works.
Steps to Hedge Crypto with Futures
- Identify Your Crypto Exposure
Determine how much cryptocurrency you hold and want to hedge. For instance, if you own 1 Bitcoin (BTC) currently worth $50,000, that’s your exposure. - Select a Futures Exchange and Contract
Choose a reputable exchange offering futures for your cryptocurrency (e.g., Binance, CME, or Kraken). Pick a futures contract that matches your crypto, considering:- Contract size: How much crypto each contract represents (e.g., 1 BTC or 0.1 BTC per contract).
- Expiration date: When the contract settles (e.g., one month or three months). Some exchanges also offer perpetual futures with no expiration, which track the spot price via funding rates.
- Liquidity: Ensure the contract is actively traded for easy entry and exit.
- Calculate the Number of Contracts
Match the size of your futures position to your crypto holding. Divide the total value of your crypto by the value of one futures contract.- Example: You own 10 BTC, and each futures contract represents 1 BTC. Sell 10 contracts to fully hedge.
- If the contract size is 5 BTC, sell 2 contracts (2 × 5 = 10 BTC).
- Take the Opposite Position
Since you’re long on the cryptocurrency (you own it), you hedge by going short on futures—selling futures contracts.- If the crypto price falls, your holding loses value, but your short futures position gains as you can buy back the contracts at a lower price.
- If the price rises, your crypto gains value, but you lose on the futures, balancing out the outcome.
- Monitor and Adjust the Hedge
Keep an eye on your position. Prices may not move perfectly in sync (due to basis risk), or your holdings might change. Adjust by adding or closing contracts if needed. With expiring futures, you may need to roll over to a new contract by closing the current one and opening another. - Close the Futures Position
When you no longer need the hedge (e.g., the risk period passes or you sell your crypto), close the futures by entering an offsetting trade—buying back the same number of contracts you sold.
How It Works: An Example
Suppose you own 1 BTC at $50,000, and you’re worried about a price drop in the next month.
- You sell 1 Bitcoin futures contract expiring in one month at $50,000.
- Scenario 1: Price Drops
- BTC falls to $40,000. Your BTC loses $10,000 (now worth $40,000).
- The futures price also drops to $40,000. You buy back the contract for $40,000, profiting $10,000 ($50,000 – $40,000).
- Net result: $0 loss ($10,000 crypto loss + $10,000 futures gain).
- Scenario 2: Price Rises
- BTC rises to $60,000. Your BTC gains $10,000 (now worth $60,000).
- You buy back the futures at $60,000, losing $10,000 ($50,000 – $60,000).
- Net result: $0 gain ($10,000 crypto gain – $10,000 futures loss).
This locks in your current value, protecting against downside risk while neutralizing upside potential.
Key Considerations
- Costs: Futures trading involves fees and margin requirements (initial and maintenance margins). If the market moves against your futures position, you may need to add funds (margin call).
- Basis Risk: The futures price might not perfectly track the spot price, slightly reducing the hedge’s effectiveness.
- Contract Types: Most crypto futures are cash-settled (settled in USD or stablecoins), not physically delivered, simplifying the process.
- Partial Hedging: You can hedge only a portion (e.g., 50%) of your holdings if you want some protection but also some upside potential.
Conclusion
To hedge your cryptocurrency with futures, sell futures contracts equal to the amount of crypto you hold. This offsets losses from price drops with gains in the futures position, stabilizing your portfolio’s value. It’s a powerful tool to manage crypto volatility, but it requires careful planning regarding contract selection, sizing, and ongoing monitoring.