Nearly every text you read about margin trading out there repeats the same advice: “stay away from leverage, it’s dangerous and you will end up losing all your money.” But did you know that leverage can be used to reduce risks? In this article, I will explain how you can use margin trading to hedge against market fluctuations when trading crypto.
Why reduce risks?
Hedging is a way to protect your portfolio, and protecting your portfolio can be just as important as making it grow. You can think of hedging as a kind of insurance. By doing it, you protect yourself against the negative impact an event can have on your finances.
That doesn’t mean you will be able to protect your portfolio from everything that could possibly happen, but if you have hedged against one specific event, like a fall in the overall market prices, you will most likely reduce the negative impact that specific event can have on your investments. In other words, hedging is a way to manage risk and anyone can benefit from learning more about it, even beginners.
How to hedge a position?
A common way to hedge is to open a position that moves in the opposite direction of your portfolio. The logic behind that is simple: if your portfolio goes down in value, the hedge will rise in value, reducing your losses. The problem with this approach is that hedging too soon or too late can reduce your overall returns. And how can you get your timing right? This approach to hedging can also be complicated to maintain since the hedges used in it are only temporary and can be very costly.
A more interesting way to hedge is, instead, to protect your portfolio from the whole market going down. This approach is interesting for you if you are confident that your choice will outperform the market, but you are not sure how the entire market will perform. That way, instead of letting your returns be determined by the market, they will rely only on your skill. That’s called a market-neutral strategy and to build a profitable one, you need to use leverage.
To have a good market-neutral position you can take a 50% long in an altcoin you like and a 50% short position in Bitcoin, since it is the best indicator of the crypto market’s performance. By doing that, if your choice of altcoin outperforms Bitcoin and the rest of the market, you will still make a profit even if the whole market goes down. However, it’s likely your profits from this approach are too small without using leverage, as you can see in the example below.
Imagine you have $1,000 of both long exposure and short exposure, and if the value of the altcoin in the long portfolio falls 5% and the value of Bitcoin in the short portfolio falls 10%, then the portfolio will have $950 of long exposure and $1100 of short exposure. In this case, you will have a total gain of $50.
To make this strategy more profitable, you can use leverage to make the difference between both positions bigger. So imagine you are using 2x leverage in both your long and short positions. In this case, your altcoin long portfolio falls 5%, it will have a total exposure of $1900 and your short portfolio a total exposure of $2,200. By using leverage, you will have a total gain of $100.
Know the disadvantages of hedging
Now that you know the basics of creating a market-neutral strategy, it’s important to learn the disadvantages of hedging before you get started. Remember, the goal of hedging isn't to maximize returns but protect from losses. The cost of the hedge can be high. Following our example above, other than the cost of creating the short position, imagine if the altcoin you chose actually underperformed the market.
With a long portfolio of $1,000 using 2x leverage and its price fell 15%, your short portfolio of $1,000 Bitcoin, also with 2x leverage, fell only 10%, you would have a total loss of $100. That is twice as much as you would lose without the leverage. However, this is still a better scenario than having invested all your funds in the altcoin and its price fell the same 15%, which would lead to a total loss of $300. A worse result than without the hedge.
The best platform to use leverage
If you are determined to learn how to trade assets using more complex features, like leverage and shorting, you should try using Morpher. The trading platform is powered by a set of smart contracts built on Ethereum and allows you to trade over 700 stocks, commodities, currencies, and other crypto. You can go long or short any market with up to 10x leverage, perfect liquidity and no commissions. Morpher is unique because the counterparty to all trades is not another user but a smart contract.
With all Morpher trades, you can never lose more than what you invest. The margin interest (a daily, non-compounding fee of 0.015% net exposure multiplied by the leverage selected) is deducted from the value of your position. This is beneficial in two ways: first, you don’t need to maintain any balance to cover the margin interest because you already provided it when you opened the position and second, you can never lose more than you put in.
Morpher has over 50,000 active users and executes thousands of trades per day.
The bottom line
There is no investment without risk. To be a successful investor, you have to learn how to manage it. Even if many people fear using leverage (and most of them with good reason), it can also be a useful tool to manage risk in a market-neutral crypto strategy. Regardless of what kind of investor you aim to be, having a basic knowledge of hedging strategies will only help you become a better investor whether you decide to use them or not.
