Trader's insurance: understanding hedging in crypto and elsewhere

Trader’s insurance. Hedging, or hedging in plain French, consists of opening a position that protects another position, like taking out insurance on a house that you do not intend to sell. The idea seems reserved for trading rooms, even though it is based on the same building blocks as those of this column, starting with short selling. Understanding hedging means understanding why certain players sell without being bearish. Capital nuance.

Hedging, definition of a position that protects another

The principle is told with an example. You hold 1 bitcoin in a long-term portfolio and you fear a downturn in the coming weeks, without wanting to sell. You then open a short of an equivalent amount on the futures contracts. If the price falls, your bitcoin's loss is offset by the short's gain. If it goes up, the portfolio's gain pays for the short's loss. Your net exposure is close to zero. You have frozen the price. Professionals speak of perfect coverage when the two legs cancel each other out exactly, a case more common in theory than in practice.

Hedging is therefore not a bet, it is a voluntary renunciation of potential gain in exchange for protection against loss. And this protection comes at a cost, between fees, financing of positions and missed gains. Insurance, once again. No one gets rich with home insurance.

Case study: airlines, miners and the CME

Hedging is as old as the futures markets. Airlines have for decades locked the price of their jet fuel months in advance, and grain growers sell their crops before they have even sown them. Crypto simply imported this plumbing. Bitcoin miners, whose costs are in dollars and revenues in BTC, sell part of their future production on the Bitcoin futures contracts of the CME, the large derivatives exchange in Chicago, to secure their cash flow.

Look at what this changes when reading the market. When a miner or fund shorts to hedge, they are not predicting a decline, they are freezing a price. Some of the short positions which inflate open interest therefore have no opinion on the market. This is why reading raw positions without context often leads to misinterpretations.

Is hedging useful to the individual trader?

Honestly, rarely in its sophisticated form. For a small portfolio, the simplest hedge is selling part of your positions, or sizing your exposure to sleep peacefully. A derivatives hedge adds fees, a risk of liquidation on the short leg and a complexity of monitoring that few individuals make profitable. The theory is elegant. The bill, less. If you want to try it, do it on a fraction of your wallet, writing down each cost to the nearest cent.