Beginners Guide: How to Hedging Your Crypto Portfolio

Key takeaways

Cryptocurrencies are volatile, which carries risks when investing. Using hedging strategies can reduce the risk of investing in crypto. Earning returns, allocating to larger projects and safely storing assets can reduce the risks associated with crypto investing.

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Crypto investors can use a number of strategies to reduce the risks associated with participating in the space.

A Guide to Hedging in Crypto

Many cryptocurrencies have hit new highs in recent weeks, while trading volumes have soared throughout the year. The crypto space is experiencing its biggest bull run to date, and while many believe the cycle could continue for at least a few more months, the market’s future movements are impossible to predict.

During market peaks, optimism can affect rational decision making. Investors may be tempted to double down on leverage or neglect risk management strategies as prices rise, which can have dramatic consequences during a downturn.

Crypto’s “HODL” mindset, which advocates holding all investments without ever selling, may not be the optimal strategy for everyone. For those looking to succeed in the crypto market, there are several proven strategies that can be used to hedge portfolios.

Dollar Cost Average

Perhaps the simplest way to manage risk in the market is by simply taking profits. However, there is risk associated with selling. Exiting the market too early can mean missing out on big profits if prices continue to climb. This is where the popular “Dollar Cost Average” (DCA) strategy comes into play. DCA involves the incremental purchase or sale of an asset rather than deploying capital in one purchase or selling one’s entire holdings. DCA is especially useful in volatile markets like crypto.

DCA helps manage price action uncertainty; it is useful in deciding when to sell. Rather than trying to identify the top of the bull market, one can simply sell in increments as the market rises.

Many successful traders implement the strategy in one form or another. Some use DCA to buy crypto every month with a portion of their salary, while others may make daily or weekly purchases. Centralized exchanges like Coinbase offer tools to automatically use a DCA strategy.

Historically, crypto bear markets have provided the best times to accumulate assets. Bull markets, meanwhile, have provided the best times to sell. Therefore, DCA is best utilized when considering the cyclical nature of the market.

Yield farming and raising

The advent of DeFi and stablecoins has provided a way for investors to earn returns on their portfolio. Keeping a portion of one’s holdings in stable coins provides a way to capture the lucrative yield farming opportunities while reducing exposure to market volatility. DeFi protocols such as Anchor and Curve Finance are known to offer double-digit returns, while the rates charged in other newer liquidity pools can be significantly higher (new yield farms are also considered riskier).

Mining crypto tokens is another effective method of generating passive income. As the assets in the game rise in price, so do returns. Meanwhile, liquid staking through projects like Lido Finance offers a way to earn returns through tokens that represent relevant assets. If the asset falls in price, strike allows the holder to continue earning interest on the asset.

On-chain and Technical Analysis

While trading and technical analysis require a level of knowledge and skill, learning the basics can be helpful for those looking to get an edge in the market. This is not to say that one should buy expensive trading courses or spend time making short-term trades. However, it can be useful to know some key indicators such as moving averages to inform decisions such as when to take profits.

Many tools also offer ways to analyze on-chain activity such as whale aggregation and funding rates. Other types of technical analysis include finding the “fair value” of assets. It can also be useful to analyze the overall picture of the market from a macro perspective as there are so many factors that can affect the market. For example, ahead of crypto’s Black Thursday event, fears surrounding the Coronavirus indicated that markets could be preparing for a major sell-off.

Asset storage and DeFi coverage

One of the most important aspects of protecting crypto is related to storage. It is extremely important to use the right kind of wallet and protect private keys. Cold wallets like hardware wallets are recommended for significant portions of funds, while hot wallets like MetaMask are generally not considered the best place to store crypto.

While investors often lock assets like ETH into smart contracts to take advantage of DeFi opportunities, there are ways to gain protection against hacks and other risks. Projects like Nexus Mutual, which looks like insurance for DeFi, offer ways to hedge risk on crypto portfolios by selling coverage against exchange hacks or smart contract failures.

Portfolio construction

Portfolio construction is another important aspect of managing risk. Choosing which assets to buy and at what amounts can have a major impact on the overall risk level of a portfolio. It is important to consider the amount invested in crypto compared to other assets and savings accounts. Moreover, choosing the right crypto projects to invest in is an important part of managing risk. Likewise, for those who trade assets, it is important to distinguish the proportion of a portfolio that can be actively used for trading.

As a general rule, it is worth considering the market capitalization of each asset in a portfolio. While major cryptocurrencies such as Bitcoin and Ethereum are volatile, they are considered less risky than many lower cap projects as they are more liquid and benefit from the Lindy effect. However, projects with lower market capitalizations can also generate higher returns. Portfolio construction ultimately depends on the risk appetite, financial goals and time horizons of each individual. The historical data shows that investing in larger capital projects can be profitable over a long time horizon.

Portfolio allocation also relates to different types of assets. This year’s NFT explosion generated huge returns for many collectors who participated in the market, but NFTs are less liquid than most other crypto tokens. NFTs are not exchangeable, while assets like Bitcoin and Ethereum trade at almost the same price on every exchange. It can also make it more difficult to find a buyer at a set price when interest in the market dries up. Since NFTs are an emerging technology in an emerging space, investing in them is still very risky.

Buy Options

Options are a type of derivative contract that gives buyers the opportunity to buy or sell an asset at a set price. For those long on a crypto portfolio, put options can be an effective way to hedge risk. Put options offer the right to sell an asset at a set price within a set time frame. This allows investors to protect their portfolio by going short in the event of a market downturn.

Conversely, call options provide an opportunity to buy the asset in the future at a set price, and are effectively a type of long commitment. If an investor takes an early profit in the event of a downturn, holding call options can allow them to buy back at a certain price if they believe the market is likely to recover in the future. Options are a complex product recommended only for advanced traders and investors, but they can provide profitable returns for users.

Finally, crypto investing can offer great returns. Historically, crypto has offered huge upside potential unmatched by any other asset in the world. Fundamentally, however, more potential reward comes with more risk. Using a variety of hedging strategies can help reduce the risk and increase the rewards the space offers.

Disclosure: At the time of writing, the author of this feature owned BTC, ETH, and various other cryptocurrencies.

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