Crypto investors can use a variety of strategies to reduce the risks associated with investing in the space.
Hedging in Cryptocurrency: A Step-by-Step Guide
Many cryptocurrencies have reached new all-time highs in recent weeks, and trading volumes have been skyrocketing all year. The cryptocurrency market is in the midst of its longest bull run to date, and while many believe the cycle will last at least a few more months, the market’s future movements are impossible to predict.
During market peaks, optimism can have an impact on rational decision making. As prices rise, investors may be tempted to increase leverage or ignore risk management strategies, which can have disastrous consequences during a downturn.
The “HODL” mentality of cryptocurrency, which advocates for holding onto all investments without ever selling, may not be the best strategy for everyone. There are several tried-and-tested strategies that can be used to hedge portfolios for those who want to succeed in the crypto market.
Averaging of Dollar Costs
Taking profits is perhaps the simplest way to manage risk in the market. However, there is some risk involved in selling. Exiting the market too soon may mean missing out on massive gains if prices continue to rise. That’s where the well-known “Dollar Cost Average” (DCA) strategy comes in. DCA entails buying or selling an asset in increments rather than deploying capital in a single purchase or selling one’s entire holdings. DCA is especially useful in volatile markets such as cryptocurrency.
DCA aids in the management of price action uncertainty; it is useful in determining when to sell. Rather than attempting to predict when the bull market will peak, one can simply sell in increments as the market rises.
Many profitable traders use the strategy in some form or another. Some people use DCA to buy cryptocurrency with a portion of their paycheck every month, while others buy it on a daily or weekly basis. Centralized exchanges, such as Coinbase, provide tools for automatically implementing a DCA strategy.
Crypto bear markets have historically been the best times to accumulate assets. Meanwhile, bull markets have provided the best opportunities to sell. DCA is thus most effective when the market’s cyclical nature is considered.
Staking and Yield Farming
With the introduction of DeFi and stablecoins, investors can now earn a return on their portfolio. Holding a portion of one’s holdings in stablecoins allows one to capitalize on lucrative yield farming opportunities while minimizing exposure to market volatility. DeFi protocols like Anchor and Curve Finance are known to provide double-digit yields, whereas rates in other newer liquidity pools can be significantly higher (newer yield farms are also considered riskier).
Another effective method of generating passive income is staking crypto tokens. As the value of staked assets rises, so do yield returns. Meanwhile, liquid staking via projects like Lido Finance provides a way to earn yield via tokens representing staked assets. Staking allows the holder to continue earning interest on the asset even if the price of the asset falls.
Technical Analysis and On-chain
While trading and technical analysis require a certain level of knowledge and skill, learning the fundamentals can be beneficial for those looking to gain an advantage in the market. That is not to say that one must purchase expensive trading courses or devote time to making short-term trades. However, knowing a few key indicators, such as moving averages, can help you make decisions like when to take profits.
Many tools also provide methods for analyzing on-chain activity, such as whale accumulation and funding rates. Finding the “fair value” of assets is another type of technical analysis. Because there are so many factors that can influence the market, it can also be useful to analyze the overall picture of the market from a macro perspective. For example, fears about Coronavirus ahead of crypto’s Black Thursday event suggested that markets were preparing for a major selloff.
Asset Storage and DeFi Coverage
One of the most critical aspects of crypto protection is storage. It is critical to use the proper wallet and protect private keys. Cold wallets, such as hardware wallets, are recommended for large amounts of money, whereas hot wallets, such as MetaMask, are not generally regarded as the best place to store cryptocurrency.
While investors frequently lock assets such as ETH in smart contracts in order to capitalize on DeFi opportunities, there are ways to protect against hacks and other risks. Projects like Nexus Mutual, which resembles DeFi insurance, provide ways to hedge risk in crypto portfolios by selling protection against exchange hacks or smart contract bugs.
Another important aspect of risk management is portfolio construction. Choosing which assets to purchase and in what quantities can have a significant impact on a portfolio’s overall risk level. It is critical to consider the amount invested in cryptocurrency in comparison to other assets and savings accounts. Furthermore, choosing the right crypto projects to invest in is an important part of risk management. Similarly, for those who trade assets, it is critical to distinguish the portion of a portfolio that can be actively traded.
As a general rule, the market capitalization of each asset in a portfolio should be considered. While major cryptocurrencies such as Bitcoin and Ethereum are volatile, they are regarded as less risky than many lower cap projects due to their greater liquidity and the Lindy effect. However, projects with lower market capitalizations can also produce higher returns. Portfolio construction is ultimately determined by each individual’s risk tolerance, financial goals, and time horizons. The historical data shows that investing in larger cap projects can be profitable over time.
Portfolio allocation also applies to various asset types. Many collectors who participated in this year’s NFT explosion made good money, but NFTs are less liquid than most other crypto tokens. NFTs are not interchangeable, whereas assets such as Bitcoin and Ethereum trade at nearly the same price across all exchanges. This can also make it more difficult to find a buyer at a fixed price when market interest dries up. Because NFTs are a new technology in a new market, investing in them is still extremely risky.
Options are a type of derivative contract that allows buyers to buy or sell an asset at a predetermined price. Put options can be an effective way to hedge risk for those who have a long position in a cryptocurrency portfolio. Put options grant the right to sell an asset at a specified price and within a specified time frame. This enables investors to protect their portfolio by selling short in the event of a market downturn.
Call options, on the other hand, provide the opportunity to purchase an asset at a predetermined price in the future and are effectively a type of long bet. If an investor takes profits early in the event of a downturn, holding call options allows them to re-enter the market at a predetermined price if they believe the market will rally in the future. Options are a complex product that should only be used by experienced traders and investors, but they can provide users with lucrative returns.
Finally, crypto investing has the potential to provide enormous returns. Historically, cryptocurrency has provided outsized upside potential unrivaled by any other asset on the planet. Fundamentally, however, greater potential reward comes with greater risk. Using a variety of hedging strategies can help to reduce risk while increasing the rewards available in the space.