Essential Cryptocurrency Risk Management

You have finally done it.

You have joined the decentralised revolution and have started to invest in cryptocurrency. You feel great about the fact that you are sticking it to the banks and taking control of your finances.

However, how safe is your portfolio? How quickly can things change in tough market conditions?

This is something that many cryptocurrency investors tend to not think about. This is not very prudent as cryptocurrencies are some of the most volatile assets in the world.

In this short post, we will look at some of the most basic risk management procedures for hedging your risk in cryptocurrency markets.

Why Are They Risky?

Before we dig into the remedies for risk, we need to take some time to recap on why cryptocurrency markets are so volatile.

One of the main things that drive the volatility in a cryptocurrency is the lack of liquidity and the prevalence of a great deal speculation and crowd behaviour. Cryptocurrency traders are very skittish and will drop a coin despite fundamentals.

Although you may have a more long term perspective on the coins that you are holding, the behaviour of the other traders can seriously impact your long term returns.

Low liquidity means that an excess of sell orders can drive the price down because of perception. There is a lack of institutional buyers on the other side to lift things up.

Moreover, there are no instruments such as futures which can try and stabilise the price.

How To Hedge Risk

One of the most effective ways to limit risk is to use instruments that will hedge falls in price. The instruments that are best able to do this are derivative instruments.

The most well known derivatitive instrument is a future contract. These are available for traders who want to trade futures on exchanges such as Bitmex. The CME and the CBOE also have these instruments.

However, if you want to hedge the risk away for other cryptocurrency assets apart from Bitcoin then you will have to think of other instruments.

One of the most well recognised other instruments that you can consider is a CFD.

Contracts for Difference

You may be asking, what is a CFD?

Quite simply, a CFD is a contract for difference. As the name suggests, it is a derivative instrument that will pay out according to the difference in the price of the underlying asset at the end of the day.

They are called derivatives as the value of these instruments are derived from the underlying cryptocurrency asset price. One can think of them as a rolling futures contract that is marked to market every day.

They are an essential instrument for hedging because like a future, you can take a long and a short position on them. The short position is the most useful for when you are hedging your long cryptocurrency portfolio.

If you wanted to use CFDs in order to hedge your portfolio, then you will need to find the most trustworthy broker. There are a number of CFD brokers with a range of different assets. Your best bet is probably to use a broker such as IQ Option.

They are regulated in Europe and have been around since 2013. Most importantly though, they have a range of different assets that you can trade. You can read more about the broker in reviews of IQ option.

Know How to Hedge

Once you have an account at a broker organised, you have to know how to hedge your positions. You will need to determine your exposure to the market. This is usually termed your delta and it is your portfolio change based on the movement of one tick in the asset.

If, however, your position is merely long the physical asset and there are no margin positions with excessive leverage, then you are safe to assume your exposure. All you will need to do is enter a short position on the asset that is equal to your notional exposure.

This will mean that for a 1 point move in Bitcoin, you will have an exact match on your short position to the movement of your long portfolio. This is what is termed a “delta neutral” hedge which means that your portfolio will not move in value.

Of course, you can choose a delta that you are comfortable with. You can have a moderate hedge on your managed accounts that will still allow you to be net long on the underlying in your physical portfolio.

Watch the Margin Call

Given that CFDs are leveraged instruments, you still have to worry about the risk of a margin call. These are the call by the broker to top up your account when the amount of funds falls below a certain level.

If the price of a cryptocurrency rallies, even though your long position in the physical asset is likely to increase in value, your sort position at the CFD broker will be losing. The result will be a fall in the value of your cash balance and a possible margin call.

Hence, you should take care to make sure that your balance is constantly monitored as you do not want to be in a position where your asset will be liquidated.

Conclusion

Cryptocurrencies can be risky investments. It is essential that you understand the risks that you are exposing yourself to when you invest in this nascent asset class.

With that being said, there is no reason that you should not be hedging your position using instruments that you have at your disposal. With the advent of CFDs, retail traders are able to structure their portfolio in a way that is best able protect them from severe moves.

Open an account at a broker and determine the amount you want to hedge. There is no reason that you should leave yourself exposed to the vagaries of the crypto markets.

Enjoy Plunged in Debt?

Pid

Subscribe to get our latest content by email.

Powered by ConvertKit

Speak Your Mind

*