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How to hedge your bitcoin holdings

By: David Marc
Updated: June 1, 2018

As any holder knows, bitcoin is a volatile beast.  Staggering price increases can be quickly followed by heartrending drops, and periods of calm are often nothing more than the eye of the great bitstorm.  Over time, holding has proven an excellent strategy; however, there are times when that roller coaster creeps to the top of that mountain, you see the first cars starting their descent, and you just KNOW you are about to speed downwards at great speed.  When you find yourself at such a moment, what can be done to protect your investment?

Hedge Bitcoin without Exchanging into USD

Thankfully, you need not sell your bitcoin in order to minimize risk.  Bitcoin futures exchanges like bitmex offer simple and effective methods to reduce your exposure or maintain exactly the same nominal value of your bitcoin during price swings.

First, big ups goes to Flood @ThinkingUSD for spelling out this hedging method:

 

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Let’s walk through exactly how this would work.  You want to hedge one bitcoin so that it maintains the exact same USD value over the coming two weeks or so, a period during which you are unable to pay any attention to the bitcoin market.  Repeat the following steps and sleep comfortably.

  1. Open an account at bitmex and deposit one bitcoin.
  2. Pick a future date with an expiration outside of the two week hedging period you have selected.  

For our purposes, the March expiration falls outside of our hedging period and is very close in price to the current spot price (perpetual in the above image).

  1. Short March 30 with your 1 bitcoin.

Note that each contract is valued at one dollar, which means that the quantity selected should be equal to the dollar value of a bitcoin.  Pay attention also that the leverage has been set on the slider on the bottom left hand side to 1X.

A limit order will actually provide a fee rebate of .025% to you, but of course if the market moves against you or the value of bitcoin drops, your order will not be filled.  A market order incurs a small fee of .075%, or .00075 of a bitcoin on your one bitcoin order. OK, so now you have purchased short contracts valued in USD at the nominal value of one bitcoin.  

4. Close the position at the end of your hedging period.

OK, your two weeks are up and you open up your computer screen mildly interested to see how bitcoin has performed.  If during that time bitcoin fell in price, your contract value would increase in bitcoin value. Assuming that the price of bitcoin fell by 10% during your two week hedge, once you liquidate your position (which may be done from the “positions” menu at the bottom of the screen) it would be worth approximately 1.1 bitcoin, minus the taker fee if relevant and a .05% settlement fee.  This 1.1 would then be equivalent in USD value to the nominal amount when you opened your order. Genius!

If, on the other hand, bitcoin appreciates by 10% in value during your two-week hedging period, your contract value would decrease in bitcoin value.  Upon liquidation, you would hold approximately .9 bitcoin (again, minus any relevant fees) which would again be equal to the USD value initially used to open the short position.  Damn.

Using leverage in hedging

With the aid of leverage you needn’t remove all of your bitcoin from the safety of your Trezor device.  Most bitcoin futures exchanges allow traders to control a large position of bitcoin with a relatively small account balance. Suppose that, instead of moving an entire bitcoin to the futures exchange, you transferred .2 bitcoin and opened a 1 bitcoin short position using a leverage of 5:1.  Just like in the previous example, you then went away on your two week hiatus, putting bitcoin out of your mind completely, secure in the belief that the nominal USD value of your holdings would just as secure as if you had shorted 1 bitcoin on a 1X leverage, as previously described.

And this is true, provided your position is not liquidated.  At a 5:1 leverage, a 20% move against your position would result in your losing the entire amount.  In the event that the market continued in the long direction, this would actually be a happy accident for you.  Your losses would be capped at .2 bitcoin, the remaining .8 in your trezor would continue to increase in USD value.  If you stuck your entire bitcoin on a 1X short, you would continue to lose bitcoin – with the nominal USD value remaining the same.  

On the other hand, if the position gets liquidated, and then there is a reversal, you are out that .2 bitcoin.  If you had the 1X short, your position would remain open, and you would suffer less of a loss.