Hedging Meaning
What Is Hedging?
In traditional financial markets, hedging is the practice of reducing one’s market risk exposure. It involves a trader or an institution opening a trading position in one market to offset potential losses in another market. This kind of investment is known as a “hedge.”
In simpler terms, a trader takes a primary position in a specific asset and a counterposition in a related asset they anticipate to move in the opposite direction. The primary goal of doing this is to protect oneself from losses rather than make a profit. By taking opposing positions, the trader aims to offset the losses from the primary position using the profits from the counterposition.
A hedge in the cryptocurrency market is analogous to a hedge in traditional markets. It refers to the process of simultaneously taking opposing positions in a cryptocurrency market. Similar to traditional markets, it serves as insurance against investment losses should the asset’s price move in an unfavorable direction.
How Does Hedging Work in Crypto?
Besides insuring against losses, hedging helps balance unexpected cryptocurrency volatility by minimizing the downside risks of digital assets. The most common crypto hedging practices include crypto derivatives (options and futures contracts), contracts for difference (CFDs), short selling, and stablecoins.
- Futures contracts – Crypto futures obligate traders to buy or sell an underlying cryptocurrency asset at a predefined price at a specific date. It hedges against potential price movement.
- Options contracts – Crypto options give traders the right, but not the obligation, to buy or sell an underlying asset at a preset price by a specific date. This means that they can choose to exercise or defer their right upon expiry.
- Contracts for difference (CFDs) – These are derivative products that enable traders to speculate on an underlying cryptocurrency’s price movement without directly owning the crypto asset.
- Short selling – Short selling refers to borrowing a cryptocurrency asset, selling it at the market price, and repurchasing it at a lower price to repay the loan.
- Stablecoins – A stablecoin is a type of cryptocurrency whose value is pegged or tied to another currency or asset, such as fiat money, precious metals, or another cryptocurrency.
While hedging crypto protects users against sudden market corrections, it is also prone to investment risks. For instance, it is susceptible to counterparty risks, where one party fails to honor its end of the deal, especially in over-the-counter trading.
