How to hedge your bitcoins against volatility? Bitcoin Futures

I have no problem holding bitcoins. However, oftentimes, I do not wish my fiat value of BTC to fluctuate too much. I hedge my bitcoins using futures market. There aren’t too much literature of hedging so far, so I'll go over what I do. In this bitcoin article, I will go over the setup, and risk involved with bitcoin hedging and trading. 

Hedging with futures trade setup:

First, you need to open a futures account. So far, only OKcoin and Huobi has futures. You can also hedge with a margin's account, but it is inferior to futures because you have to put up more margin and pay interest borrowing BTC. I have an account at okcoin with referral code, feel free to open an account under me.

How do you hedge your coins? Essentially, you sell futures contract (almost like shorting) on the open market at a price you want. I'll give you an example. If current futures market is trading at 300 dollars and you have 100BTC, the amount in USD you want to hedge is 30k. Therefore, the number of contracts you want to sell is 300 ($100 per contract).

The second part is picking an expiry, that is the amount of time you want your futures to be hedged. OKcoin offers 1Week/2Week/Quarter. The price of different expiry varies. This is dependent on a number of factors such as market sentiment, contango/normal-backwardation, and interest rate. I'll highlight each one of them below.

Once you have picked the expiry date and sold your contracts, you are hedged. If price fall, by 5%, your value of BTC drops by 5%, but you would gain 5% more BTC from the contracts you sold short and vice versa.

Risk with futures:

There are risks associated with hedging in an unregulated market. Unlike commodities or index futures markets like COMEX or NYMEX, there is no insurance and weaker risk management. The risk are highlighted below:

  • Counterparty risk, if OKcoin or BitVC goes belly up for any reason.
  • System clawback, insurance fund is allocated to minimalize clawbacks.

There is always a chance (maybe very small) that the exchange you trade at will fail. Bitcoin exchanges doesn't have SIPC, insurance for exchange and broker failures. In that case, your loss is about 10%, the margin you put up to hedge your coins. You should always keep most of your coins offline.

There is also a chance that market isn't liquid enough to cover all margin called contracts, in that case, there is a clawback system. Basically, the losses from margin-called contracts are subtracted from the profitable positions. Since you are hedging, you would only be subject to a clawback if price crashes; your futures position is profitable. If price rises, you would be at a loss, so you don't have clawback. 

There is an insurance fund which is used in the off chance that this happens. In conclusion to this subject, it is fairly safe to say clawback isn't a big issue. Since futures inception, OKcoin has 2 accounts where clawback happened. Once at 6% where BTC dropped 25% in 2 days and the other at 0.7%.

Why futures price varies with different expiration dates?

Quote from investopedia:

A situation where the futures price of a commodity is above the expected future spot price. Contango refers to a situation where the future spot price is below the current price, and people are willing to pay more for a commodity at some point in the future than the actual expected price of the commodity. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today.

The opposite of contango is known as normal backwardation. A market is "in backwardation" when the futures price is below the expected future spot price for a particular commodity. This is favorable for investors who have long positions since they want the futures price to rise.

Interest rate is another factor that affects futures price. If a speculator decides to go long by buying a futures contract, he is heavily leveraged. In this case, it is 10/20x of his margin. Therefore, interest rate is discounted into the contract length. Hence the price of futures should be slightly above the spot price if  interest rate the only factor.

That is all there is to trading and hedging your BTC in this volatile market. Did you find this article useful? If so, take a look at my other articles at my trading guide page. You can also create an new account under me for OKcoin or Bitfinex with referral code