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A Guide to Hedge Using Futures Contract

by Rahul Kohali 2 months ago in investing

All you need to know about the Futures contract in Trading

Futures trading is itself a hedging exercise that existed since time immemorial. When terms like stock market or similar were in oblivion, buyers used to lock-in the price of an asset by making an advance payment to sellers. Likewise, sellers with speculation of sluggishness in the future market, tend to make a contract before the produce or asset was ready to be sold. So, in a way both the buyers and sellers want some sort of protection or hedge against an anticipated economic fluctuation.

Traditional commodity, stock or crypto – no matter what trading option you bet on, hedging is an important tool against any unexpected fluctuation due to any reason – known or unknown.

If you are an investor in the crypto futures market, here are some proven hedging tools that provide not just extra indemnity to your investment, but also help you maximize your profit. These tools are an icing on the cake.

Before we talk about the new tools of hedging, it would be imperative to learn the basic concept behind them.

Hedging in futures is strategically creating new positions for trading so that the loss or gain gets distributed and the risk is minimized. Gain or loss in one position neutralizes the changes to the value on other positions.

Here are three most popular hedging tools in futures trading.

Short-selling

Breaking a long-term futures asset into multiple shorter assets is called short-selling. Hedging breaks the position size and reduces the risk factor. It’s acquiring a position to sell the short assets to reduce the risk factor. For instance, if you have an USDT 1,000 in the futures market, and you are skeptical about the market performance, hedging the investment by creating 10 positions of USD 100 each, will reduce the risk factor as each of the positions will act as a separate investment and fetch a separate outcome – profit or loss.

Sometimes, the earnings from the short asset can help you to buy it back for a lower price. This way, you earn profit from the difference.

Fortunately, PCEX Member is one among a few of the exchanges that offer short-selling hedging benefits. However, there is a catch. If the market goes up, you incur loss as you borrowed the asset at a lower value, and now you have to purchase it by paying more.

Hedging with CFDs

If the market goes up, you are on the verge of making a loss in the short-selling hedge technique. CFDs (Contract for Difference) provides a solution to the risk. Like the futures market, CFDs are too a derivative product but with the benefit of short-selling. They let you speculate on financial markets without owning the underlying assets. You can speculate in either direction – ups and downs. If the futures market moves up, you make profit, if it goes down, you incur loss. However, the multiple short positions will help you to strike a balance. Thereby, it provides a better immunity against any drastic changes in the crypto assets value.

Interestingly, CFDs allow you to take two positions on the same cryptocurrency, at the same time, but in opposite directions. This concept is called direct hedging. This further shields your investment against any potential damage. As a matter of caution to safeguard the investment from abrupt fall, consider using limit and stop options.

Long Straddle

Contrasting the above two tools that focused on selling out the assets to gain stability or secure the investment portfolio, Long Straddle is a hedging option when you invest or buy more assets. In this, you invest in the futures market buying a certain lot-size with Call (buy) and Put (sell) options at a specific price, and fix an Exercise Price (EP) to a specific price. This EP is a right to buy and sell at EP. Thereby, depending upon the market scenario at the expiry date, you can exercise the right to buy or sell. The two likely scenarios to happen on the expiry date are as follows:

The price of the crypto moves above the EP: The investor has both the options in hand – buy or sell. If the price increases beyond EP, the investor will like to exercise the Call option and abandon the Put, i.e., buy more assets. Remember the investor has the right to buy the same asset from the exchange at a price below the actual price.

The price of the crypto slips down the EP: The investor will like to exercise the Put option and abandon the Call, i.e., sell the asset because he or she has the right to sell it at a price higher than the market price.

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Rahul Kohali
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Rahul Kohali
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