Updated July 18th, 2019
Hedging is an investment action taken to minimize the risks associated with investing in a given asset. Bitcoin is by far one of the most volatile assets ever traded for profit. As such, when bitcoin is to be hedged, it is sold for an alternative asset to minimize the risks associated with holding bitcoin in a bearish market in order to reduce losses or maximize gains.
The idea is quite simple, especially during periods of bullish market trends. When the price is going up, all you have to do to maximize your profits is to “hold” your bitcoins. On the other hand, when price is expected to drop, you would want to sell your bitcoins for another asset whose price is more stable. By doing so, you are hedging your bitcoin assets against expected bearish market movements. Thereafter, when the market’s trend changes and price starts to rise again, you can buy your bitcoins back at a lower price, which increases the chances of making even more profits.
During the past few years, several studies attempted to investigate the hedging capabilities of various financial assets against bitcoin in an attempt to find the best way to minimize losses during bitcoin market downtrends. Gold, USD, CHF, EURO, SP500, KOSPI, and many other assets have been examined to identify their efficiency in hedging bitcoin. These studies implemented tri-variate measurements using VGARCH and VARMA to identify the best assets that can reduce losses during bearish periods of bitcoin markets. Most studies have shown that gold and CHF can serve as positive hedging assets against bitcoin’s downwards market trends. Declining bitcoin prices were associated with a rise in the prices of gold in UK, Japanese, and Indian markets. On the other hand, bitcoin was found that it could be positively hedged, although not with the same positive magnitude as with gold and CHF, with stock market indices, especially FTSE100, S&P 500, KOSPI, and Kikkei225.
A recently published research paper examines the potential of hedging bitcoin via other financial assets. The study compared the optimal hedging ratios of various potential assets. On the other hand, the competing GARCH models of various assets were compared to identify the hedging effectiveness of each asset. The study calculated the optimum hedging ratios between bitcoin and other possible hedging financial assets using a variety of GARCH models during the period between January 3rd, 2011, and February 19th, 2018. The study revealed that gold represents the best financial asset to be used for hedging against bitcoin’s bearish market periods. Via means of results obtained from the application of the generalized orthogonal GARCH model, which provides the optimum evidence regarding the maximum effectiveness of hedging of a given financial asset, it was concluded that $1 long of bitcoin can be efficiently hedged via means of $0.70 short of gold. The findings of this study are considerably robust when compared to alternative specifications.
In order to be able to implement hedging practically during rapidly moving market conditions, as a trader, you should rely on using one of the bitcoin exchanges that enables you to instantly sell your bitcoins for fiat and then be able to use the fiat money to purchase other assets. As such, using exchanges that would send the fiat money to your bank account, such as Coinbase, would not be helpful. Exchanges such as Kraken would be extremely useful in this regard, as you can sell your bitcoins for fiat money and then purchase them back in a matter of minutes. On the other hand, brokers that offer the trading of cryptocurrencies, including bitcoin, forex pairs, commodities such as gold, and stock indices would also be extremely useful for a trader who wishes to adopt hedging as a strategy to minimize losses during bearish market periods and increase gains during bullish periods.
In the end, it is worth mentioning that even though bitcoin is by far a highly volatile asset, adoption of hedging can be extremely useful in reducing losses when its price goes down. Hedging bitcoin using relatively stable financial assets, especially gold, can be extremely useful during periods of downwards trends or uncertain conditions. Following the charts and the news closely can be very useful to minimize losses.