Discover short and long hedging strategies for trading crypto futures contracts. Understand how to use these techniques to manage risk and potentially enhance your trading outcomes.
Crypto futures contracts provide sophisticated tools for digital asset traders. Delve into how to leverage long and short hedging within your crypto trading activities.
Key Takeaways:
- Crypto futures contracts allow for two main hedging strategies: the short hedge and the long hedge.
- Employ a short hedge, taking a short position in crypto futures, to protect against potential price declines in your assets.
- Implement a long hedge, using a long position in crypto futures, to guard against anticipated increases in asset prices.
- Perpetual contracts, similar to futures but without a set expiration, are prevalent in the crypto market.
- Explore methods for minimizing basis risk in your futures trading, outlined below.
Hedging with Crypto Futures
The world of crypto futures trading opens the door to risk management through two crucial hedging approaches: the short hedge and the long hedge.
Understanding the Short Hedge
A short hedge, utilizing a short position in futures contracts, offers a way to cushion against the impacts of expected drops in asset values. Traders and businesses frequently apply this tactic to assets they are planning to sell.
Short Hedge – Key Points:
Let’s consider an oil producer who enters a contract on January 15th to sell one million barrels of crude oil, setting the sale price based on the market rate on July 15th. Every $1 increase in oil price over these six months would mean an extra $1 million for them, but conversely, a $1 decrease would mean a $1 million loss.
Simultaneously, crude oil futures for July are trading at $100 a barrel. The hedge ratio, calculated as value at risk divided by notional value, comes to ($100 × 1 million)/($100 per barrel x 1,000 contracts) = 1,000 contracts. The producer hedges effectively by selling short 1,000 futures contracts. Upon closing this position on July 15th, their aim is to secure a price close to $100 per barrel, totaling $100 million.
Scenario 1: If the spot price rises to $102 a barrel by July 15th, the company receives $102 million (= $102 x 1 million) for the oil. Assuming the futures price mirrors the spot price upon expiry for simplicity, the company loses $2 per futures contract ($102 – $100), totaling a $2 million loss on the futures position. Consequently, they end up with a net revenue of $(102 – 2) million = $100 million.
Scenario 2: Conversely, if the spot price dips to $96 a barrel on July 15th, the company obtains $96 million for the oil. They then gain $4 per futures contract ($100 – $96), adding up to $4 million on the futures position. Thus, their total revenue remains at $(96 + 4) million = $100 million.
This example demonstrates how a short hedge strategy helps fix revenue at approximately $100 million, regardless of price fluctuations.
Exploring the Long Hedge
A long hedge, which involves taking a long position in futures contracts, provides protection against future increases in asset costs. This approach is frequently adopted by individuals or companies planning to make purchases of specific assets.
Long Hedge – Key Points:
Let’s assume a manufacturer agrees on January 15th to supply 100,000 tons of steel on July 15th. On January 15th, the current market price for steel is $630 per ton, while the futures price for July delivery is $600 per ton. The manufacturer hedges by buying futures contracts and closing them on July 15th, where each contract represents 100 tons of steel. This is designed to lock in a steel price of $600 per ton, totaling $60 million.
Scenario 1: Imagine the purchase cost rises to $660 per ton. Assuming the futures price matches the spot price at expiry for the sake of simplicity, the manufacturer earns $(660 – 600) × 100,000 = $6 million on the futures position. As the steel purchase costs $660 × 100,000 = $66 million, the net cost equals $(66 – 6) million = $60 million.
Scenario 2: If the purchase cost is $520 per ton, the manufacturer faces a loss of $(600 – 520) × 100,000 = $8 million on the futures position. Since purchasing the steel costs $520 × 100,000 = $52 million, the total net cost is $(52 + 8) million = $60 million.
In these examples, we’ve simplified the scenarios by assuming no daily settlement. In reality, daily settlement affects the outcome of futures contracts day by day, which can have a small impact on hedging performance.
Understanding Basis Risk in Crypto Futures
The previous examples assume perfect hedges, thereby removing any uncertainty surrounding future prices. However, in practice, hedging always involves the potential for basis risk. Basis risk defines the difference between the spot price of the asset being hedged and the price of the related futures contract.
If the asset being hedged is identical to the underlying asset in the futures contract, the basis should be zero upon the contract’s expiration. Before expiration, the basis can be either positive or negative, influencing the hedger’s position. An increase in the basis is referred to as a strengthening of the basis, whereas a decrease is called a weakening of the basis.
Basis Risk – Long vs Short Hedging
For short hedges, an unexpected strengthening of the basis improves the hedger’s financial outcome. This is because the hedger ultimately sells the asset at a higher price, which offsets losses from the futures contract. On the contrary, an unexpected weakening of the basis negatively impacts the hedger.
The reverse is true for long hedges. When the basis unexpectedly strengthens, it negatively affects the hedger. In this case, the hedger must pay more for the asset, offsetting gains from the futures contract. However, a weakening of the basis enhances the hedger’s position.
Basis risk typically rises as the time between the hedge expiration and the futures delivery month lengthens. As a general guideline, it’s best to choose a delivery month that is as near as possible to, but later than, the hedge’s expiration date. If a futures contract has delivery months of March, June, and September, the March contract is the best option for expirations in December, January, and February to lessen basis risk.
Comparing Crypto Futures and Options
Crypto futures and options are common types of derivatives employed in trading, yet they differ fundamentally. Here are several key differences. To dive deeper, check out our pieces on option basics and option strategies to better understand their applications and trading tactics.
Rights and Obligations
Futures contracts are legally binding, obligating both the buyer and the seller to buy and deliver the underlying assets as per the agreement. In contrast, options provide the buyer with the right, but not the obligation, to either buy (call option) or sell (put option) the asset. The seller of the option must fulfill the agreement based on the buyer’s decision.
Potential Gains and Losses
Both buying and selling futures contracts carry the potential for unlimited profit or loss. With options, however, the payoff structure is ‘asymmetrical’. Buyers enjoy potentially unlimited gains with a maximum loss limited to the premium paid, while sellers have a maximum gain capped at the premium received but face unlimited potential losses.
Premiums and Margin Requirements
To initiate a futures position, users need to deposit margin irrespective of whether they are buying or selling. For options, the buyer pays a premium when the contract begins and isn’t required to post margin; however, the option seller must provide margin.
Perpetual Contracts Explained
Perpetual contracts resemble traditional futures but lack a defined expiration or settlement date. They are notably favored in crypto, allowing traders to maintain leveraged positions without having to deal with expiration issues.
Through a ‘funding rate’ mechanism, perpetual contracts tend to trade closer to the index price of their underlying asset compared to traditional futures.
The index price reflects the average spot price of the asset across multiple exchanges. A funding rate combines two key elements: the interest rate and the premium. The interest rate is generally constant, dependent on the borrowing rates for the assets specified in the contract. The premium is the difference between the perpetual price and the mark price, derived from the index price.
If the funding rate is positive, those with long positions pay those with short positions. If it’s negative, the reverse occurs. The calculation for funding is as follows:
Funding = Position Value × Funding Rate
Funding rates encourage traders to buy perpetual contracts when the contract price is below the index price, and to sell when it exceeds it. This ensures that the contract price closely follows the price of the underlying asset. The Crypto.com Futures Contract Trading FAQs offer more insight on using margin when trading futures contracts.
Traders using perpetual contracts should be familiar with the tick value and typical tick movements for the futures contract they are trading. These factors influence profit/loss outcomes and impact the volatility of their futures positions.
Exploring Advanced Trading Strategies
Besides familiarizing yourself with the basics of futures contracts, it’s useful to explore the basics of an exchange. Learn about how cryptocurrency exchanges function, their operating models, and the different order types that traders can use.
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