Understanding Hedge Approaches in Futures Trading: Short vs Long Strategies | by LBank Exchange | Jun, 2023

If you’re new to cryptocurrency trading, you might have encountered traders on different social platforms discussing being “fully hedged.” While it may sound intriguing, this term simply refers to traders operating a futures account. Being “fully hedged” means they have both long and short positions open simultaneously.

Traders employ this strategy when it’s challenging to predict the market’s direction. Both long and short positions help minimize potential losses and capitalize on market fluctuations. For instance, if the price of Bitcoin suddenly drops, the trader will profit from the short position while experiencing a loss in the long position. The short hedge and long hedge are two primary hedging strategies commonly used in trading crypto futures. This article will delve into effectively utilizing both strategies in trading crypto futures. But first, what is Hedging?

Hedging is a valuable strategy aimed at minimizing potential investment losses by taking a position expected to move in the opposite direction of an existing one. It is a tool traders use in managing their exposure to the volatile nature of the crypto market. With hedging strategies, traders can effectively reduce the risks associated with price fluctuations and maintain a more balanced investment portfolio.

In crypto futures, when a trader decides to open a long position, that is, they buy a contract worth a certain amount of an asset and hope for price stability. If the asset price goes up, they may take a profit, and if the asset price drops, the trader may exit the position and take the loss. In another scenario, they wait for the next price increase and probably take out their capital. This strategy essentially helps in mitigating the risk of trading.

To better understand the concept of a long-hedge, let’s assume a trader needs 2000 ETH to fulfill a contract in the next few months. The current spot price for ETH is $1500, but the futures price is $1400. In this scenario, the trader decides to take a long position in a futures contract on Ethereum.

If the targeted spot price of Bitcoin eventually exceeds $1400, the trader profits. On the other hand, if the targeted spot price of Bitcoin falls below $1400, the trader incurs a small loss on the futures position. However, they still save overall due to the lower-than-anticipated purchasing price.

As opposed to a long-hedge, taking a short-hedged position involves shorting/selling futures contracts hoping that the price will drop. When the price decreases, the short position yields a profit, while an increase in the asset price results in a loss for a short position.

For example, suppose a trader exits a trade due to market uncertainty and the asset price increases. The trader wants to make sure they still make a profit even if the asset price goes down. So they decide to do something called a “short hedge.” This means they make a special kind of trade where they promise to sell a certain amount of oil in the future at a specific price. Doing this protects them from losing money if the asset price falls.

By doing such a short hedge, the trader protects themselves from losing money on the sale of the initial position even when the price went down.

As much as both long and short hedges help in trading the futures market successfully, they both share in common what is known as ‘Basis risk.’ In simple terms, basis risk is the difference between the spot price of an asset and the price of the futures contract used for hedging. It poses a challenge in fully offsetting pricing risk, but a high hedge ratio in a long hedge can significantly reduce basis risk. On the other hand, a short hedge protects the seller by locking in the sale price of an asset.

In a short hedge, a stronger basis unexpectedly benefits the hedger since they receive a higher price for the asset when gains or losses from the futures contract are taken into account. Conversely, a weaker basis negatively affects the hedger’s position.

For a long hedge, an unexpected strengthening of the basis worsens the hedger’s position as they have to pay a higher price for the asset when considering gains or losses from the futures contract. If the basis weakens unexpectedly, it improves the hedger’s position.

To mitigate basic risk, a practical approach is to choose a delivery date that is as close as possible to the expiration of the hedge but still later than that.

Although various traders opt for setting a stop-loss to mitigate losses, opening both long-hedged and short-hedge positions can serve as an additional safeguard against erratic market moves. This method is constrained solely by time rather than the price of cryptocurrency. However, it is essential to always do your own research before delving into the trading markets.

Disclaimer: The opinions expressed in this blog are solely those of the writer and not of this platform.