Hedge Trading
How to get insurance on your trades!
Hedging is commonly known as insurance for your trades.
Hedging is a practice that is used to manage one’s risk in an unforeseeable situation in the market.
You must have heard about institutions called Hedge funds, which are probably the biggest users of this technique.
How does Hedging work?
Hedging is done by offsetting your trade with another asset that generally has an opposite movement to your current trade.
Too confusing?
Let us take an example:
If I take a trade of saying shorting Bitcoin at $28615 with $1000 at 3x lev, seeing that the market sentiments are pre-dominantly bearish, but if I want to still minimize my loss in case the trade goes into loss I can find an asset that will have an inverse movement to this trade.
So lets say we short BTC and long/SPOT buy ETH with 500$ and 3x lev as ETH generally gains 2% for every 1% move in BTC (assumption). This relative strength of ETH vs BTC helps us hedge our trade.
Now both of these trades combined will act as hedge trades. If the market goes up then we will be in loss but not that significant loss, if it goes down then we will be in profit.
So it helps us ensure our short is in play with minimum risk.
Let us see how it goes-
BTC went opposite of our trade and Hit our SL-
loss from BTC-
(1.75*3)% of 1000$ = 52$
Now lets see how ETH performed-
ETH Moved up 8.5% in the same timeframe.
Profit from ETH (considering Spot trade)-
8.5% of 500$ = 42.5$
Net Loss = 52-42.5 = -9.5$
Loss if the trade was not hedged = 52$
In this way, we can hedge trades to insure against unforeseeable circumstances. Of course, this is a very broad example and doesn’t cover all the cases. But hopefully, this helps you understand the basics of how it works.
Does hedging always work?
Nothing in the markets “always works” let’s say in the above example BTC went up and ETH went down then the loss will be 2x, we can also see some conditions where ETH doesn’t rise enough to cover the losses effectively, etc.
It takes careful consideration to pick what your hedge will be against a given trade. It needs practice and patience.