Understanding hedging mode

Definition and Principles of Hedging

Hedging is one of the main financial functions of futures products. It refers to using futures to offset the price fluctuations of the underlying digital assets, thereby avoiding risks caused by price volatility during this period. Hedging is divided into long hedging and short hedging, which are suitable for clients who wish to buy the digital asset in the future and those who wish to sell the digital asset in the future, respectively.

The theoretical basis of hedging: The trends of the spot and futures marketplaces tend to align (under normal marketplace conditions). Since both marketplaces are influenced by the same supply and demand relationships, their prices rise and fall together. However, because operations in these two marketplaces are opposite, profits and losses are also opposite. Profits in the futures marketplace can offset losses in the spot marketplace, or appreciation in the spot marketplace can be offset by losses in the futures marketplace.

The Basic Characteristics of Hedging

The basic characteristics of hedging: At a certain point in time, simultaneous buy and sell activities of the same type of digital asset are carried out in equal quantities but on opposite sides in both the spot market and the futures market. That is, while buying or selling in the spot market, an equivalent amount of futures is sold or bought in the futures market. After a period of time, when price fluctuations result in profits or losses in the spot trades, these can be offset or compensated by the gains or losses from futures trade. In this way, a hedge mechanism is established between the 'spot' and 'futures', as well as between the near-term and long-term, to minimize price risk as much as possible.

Hedging transaction principles

1. Principle of opposite transaction side;

2. Principle of the same type of digital assets;

3. Principle of equal quantity of digital assets;

4. Principle of same or similar month.

Investors use the futures marketplace for hedging transactions, which is essentially a risk investment activity aimed at avoiding spot trade risks, and is an operation combined with spot trade.

Types of hedging

Depending on the side of participation in futures trading, hedging transactions can be divided into two types: buy hedging and short hedging.

1. Buy hedge

Also known as long hedging, this method can be used when investors believe that the price of a coin will rise in the future and need to pay the corresponding digital asset at a certain time in the future.

For example, Zhang San is a Bitcoin miner and needs 10 Bitcoins next month to pay for electricity. At this time, the price of Bitcoin is $60,000. Zhang San is worried that the price of Bitcoin will rise by the time he needs to pay, causing him to miss out on the return from the price increase. In this situation, Zhang San can use 1 Bitcoin as margin, choose 10x leverage, and buy a call futures on the OKX platform to hedge the risk.

Suppose that in one month, the actual price of BTC is $70,000 per coin.

At this point, the profit from the contract is: (100 USD (contract size)/60,000 USD (entry price) - 100 USD (contract size)/70,000 USD (exit price)) * 6,000 (contract quantity) ≈ 1.43 units. After selling at a price of 70,000 USD per unit, the actual profit = 70,000 * 1.43 ≈ 100,000 USD.

Spot marketplace loss: (60,000-70,000)*10 = -100,000 USD.

By the return from the call contract, Zhang San successfully offset the losses caused by the spot marketplace's rise.

2. Sell hedging

Also known as short hedging, when investors are concerned that the price of a coin may fall in the future and cause their digital assets to depreciate, they can use this method.

For example, Li Si is a Bitcoin holder with 10 Bitcoins. He’s worried that Bitcoin might drop in the future, causing the value of his holdings to shrink. At this point, Li Si can use 1 Bitcoin as margin, choose 10x leverage, and open a put futures on the OKX platform to hedge his risk.

Assuming the current BTC price is $60,000 per coin, and the BTC futures price is also $60,000 per coin. The return Li Si needs to lock in = 10 BTC * $60,000/BTC = $600,000, and the MCap of each futures is $100. Therefore, the quantity of futures Li Si needs to open short = $600,000 / $100 = 6,000 conts.

Suppose that in one month, the actual price of BTC is $70,000 per coin.

The return from the futures is: (100 USD (contract size) / 70,000 USD (exit price) - 100 USD (contract size) / 60,000 USD (entry price)) * 6,000 (contract quantity) ≈ -1.43, meaning the BTC contract loss is 1.43 BTC. Therefore, the actual number of BTC the miner can sell is 10 - 1.43 = 8.57 BTC. After selling at a price of 70,000 USD per BTC, the actual return = 70,000 * 8.57 ≈ 600,000 USD.

Suppose that after one month, the actual price of BTC is $50,000 per coin.

The return from the futures is: (100/50000-100/60000)*6000=2BTC, which means the futures' return is 2BTC. The total quantity of BTC the miner can sell is 10+2=12BTC, with a selling price of $50,000 per BTC. The total return after selling is 12*50,000=$600,000.

As mentioned above, by establishing corresponding futures positions in advance, investors can use hedging to lock in their final USD returns.

Hedging basis

Hedging can generally offset the risk of price fluctuations in the spot market, but it cannot eliminate risk entirely, mainly because of the existence of the "basis" factor. To deeply understand and apply hedging and avoid price risk, it is essential to grasp the concept of basis and its fundamental principles.

Basis refers to the difference between the spot price and the futures contract price, that is: Basis = Spot Price - Contract Price.

The basis is a dynamic indicator that reflects the actual changes between the contract price and the spot price. The basis can be either positive or negative, mainly depending on whether the spot price is higher or lower than the contract price. If the spot price is higher than the contract price, the basis is positive, also known as backwardation or spot premium; if the spot price is lower than the contract price, the basis is negative, also known as contango or spot discount.

Although the direction of change for futures prices and spot prices is the same, the magnitude of their changes often differs, so the basis is not constant. As spot prices and futures prices continue to fluctuate, the basis sometimes widens and sometimes narrows. Ultimately, because spot prices and futures prices trend in the same direction, the basis tends to approach zero during the delivery month of the expiry futures.

For buyers engaging in hedging, they prefer to see the basis weaken; for sellers engaging in hedging, they prefer to see the basis strengthen.

Changes in basis are crucial for hedging. If the basis is relatively large when opening a hedging position, and the basis narrows when the hedge is closed or delivered, it may result in a loss, though it could also lead to a profit. Therefore, hedging is not a one-and-done process; investors need to constantly monitor changes in the basis and choose favorable timing to complete transactions, in order to achieve better hedging results and even gain additional returns.

Although hedging does not provide complete insurance, it does avoid price risks caused by unexpected factors. Essentially, hedging is an exchange of risks—trading price fluctuation risk for basis fluctuation risk.

FAQ

Q: How do you determine the number of contracts to place for hedging?

On OKX, each BTC contract has a contract size of 100 USD, while contracts for other cryptocurrencies have a face value of 10 USD.

Order quantity = current futures price / futures size * number of positions to be hedged.

For example, if the current price is 60,000 USD, the BTC contract size is 100 USD, and the number of Bitcoins to be hedged is 10.

Order quantity = 60000/100*10 = 6000 contracts.

Q: How much margin should I prepare?

In hedging, the main purpose of margin is to prevent liquidation, so of course, the more the better. However, you also need to consider capital utilization. Specifically, you can decide based on the current market volatility and the timing of adding margin.

For example, if you believe that BTC won't crash by 20% within an hour and you can add enough margin within that hour, then the margin level can be kept within 300%. However, if you're worried that you won't be able to add enough margin within an hour and might need 12 hours or even more time to add margin, and you're also concerned that BTC might crash by 30% during that period, then the margin level may need to be kept above 400% or even higher.

Q: What should I do if my hedged position is about to be liquidated?

When hedging, it's best not to let the position get liquidated. If liquidation is imminent, you need to continue to add margin for protection. If you close the position, it essentially becomes a trend trade, which carries higher risk.

Q: When should you close your position and stop hedging?

It specifically depends on the investor's expectations and the type of futures involved. For example, if your expectation is for one month and you need to lock in the value of your Bitcoin during that month, then you should flatten your position at the end of the month. You shouldn't take unnecessary risks out of greed for Markets.

If the expiry futures you participate in is a delivery contract, there will be a delivery time, so you need to pay attention to the delivery date. If you make a profit on this futures, withdraw the profit. If you incur a loss this month, add more margin. After the delivery is completed, you can continue hedging operations based on your own situation.

Q: When hedging, is there a way to eliminate or reduce the impact caused by basis changes?

This problem can be solved through statistical arbitrage. When the basis is too large during hedging, you can solve this problem by shorting the basis.