Hedging Strategies
What is Hedging
Hedging is opening a position in the opposite direction to reduce risk on an existing position. Similar to insurance, you pay a cost to protect against risk.
If you're holding BTC long-term but worried about short-term downside, you can reduce that risk using derivatives without selling your spot holdings. This is the core value of hedging.
Hedging is not about maximizing returns - it's about managing risk. When you hedge, you reduce potential gains on the upside, but you also reduce losses on the downside.
Hedging Spot with Futures
Basic Structure
Holding spot BTC while opening an equal-sized BTC futures short makes your position neutral regardless of price movement.
| Price Movement | Spot P&L | Futures Short P&L | Net |
|---|---|---|---|
| +10% | +$10,000 | -$10,000 | $0 |
| -10% | -$10,000 | +$10,000 | $0 |
Full Hedge vs Partial Hedge
Full Hedge (100%):
- Futures short for entire spot quantity
- Completely eliminates price movement impact
- Effectively the same as having sold your spot
- Use case: Eliminating price exposure without a tax event, or temporary protection
Partial Hedge (e.g., 50%):
- Futures short for half of spot quantity
- Losses cut in half on downside, but gains also halved on upside
- Use case: Reducing downside risk while maintaining some upside participation
Costs
- Funding rate: Short positions receive or pay funding. Positive funding means shorts earn; negative means shorts pay
- Trading fees: Fees for opening/closing positions
- Margin opportunity cost: Capital tied up as futures margin
Hedging with Put Options
Protective Put
Holding spot BTC + buying BTC put options. Unlike futures hedging, this protects the downside while maintaining upside gains.
| Price Movement | Spot P&L | Put Option | Net |
|---|---|---|---|
| +20% | +$20,000 | Expires worthless (-premium) | +$20,000 - premium |
| -20% | -$20,000 | +$20,000 - premium | -premium only |
Cost and Effect
- Cost: Put option premium (like an insurance premium)
- Maximum loss: Limited to put option premium
- Upside participation: Unlimited (reduced by premium amount)
Put option premiums vary by strike price and expiry:
- At-the-money (ATM) puts: Expensive but complete protection
- Out-of-the-money (OTM) puts: Cheaper but no protection until a certain decline
Futures Hedge vs Put Hedge
| Aspect | Futures Short Hedge | Put Option Hedge |
|---|---|---|
| Cost | Low (fees + funding) | High (premium) |
| Upside participation | None (offset) | Yes |
| Flexibility | Requires active management | Automatic protection until expiry |
| Liquidation risk | Yes (futures position) | None |
| Best for | Short-term definite protection | Uncertain but prepared for decline |
Delta Neutral Strategy
Concept
Delta neutral is a strategy that maintains the portfolio's total delta at zero to pursue returns regardless of price direction.
Spot + Futures Short (Basic Form)
The simplest delta neutral: buying spot + shorting equal amount of futures.
- Price direction irrelevant
- With positive funding rate: Short position receives funding = profit
- With negative funding rate: Short position pays funding = cost
Sources of Return
| Source | Description | Condition |
|---|---|---|
| Funding rate | Shorts receive during positive funding | Funding rate > 0 |
| Basis | Futures convergence profit in contango | When using dated futures |
Funding Rate Arbitrage
Strategy Structure
When funding rate is positive (longs pay shorts):
- Buy 1 BTC spot ($100,000)
- Short 1 BTC perpetual futures ($100,000, 1x leverage)
- Price movements offset, making you price-neutral
- Receive funding every 8 hours
Return Calculation Example
Funding rate 0.03% (per 8 hours), position size $100,000:
| Period | Collections | Funding Revenue |
|---|---|---|
| 1 day | 3x | $90 |
| 1 week | 21x | $630 |
| 1 month | 90x | $2,700 |
| 1 year | 1,095x | $32,850 |
This represents approximately 32.8% annualized return. Of course, funding rates fluctuate, so actual returns vary.
Risk Factors
Funding Rate Direction Change: If funding turns negative, shorts must pay instead of receive. In this case, you need to close the position, and entry/exit trading fees become losses.
Liquidation Risk: If margin for the futures short becomes insufficient, liquidation can occur. Even at 1x leverage, liquidation is possible during sharp price surges if not using cross margin. Maintain sufficient margin.
Exchange Risk: Running spot and futures on the same exchange means both are at risk if the exchange fails or goes bankrupt. Spreading across exchanges adds operational complexity.
Slippage and Fees: Entry/exit slippage and trading fees occur. Funding rate revenue must significantly exceed these costs to be worthwhile.
Execution Conditions
Consider funding rate arbitrage when:
- Funding rate consistently positive (at least 0.01%)
- Sufficient capital ($10,000+ recommended)
- Low trading fees (VIP tier or maker discounts)
- 24-hour monitoring possible (or automation)
Covered Call for Yield Enhancement
Strategy Structure
Holding spot BTC + selling BTC call options.
- Receive call premium to enhance holding returns
- If price rises above strike, you miss the upside
- Most effective in sideways markets
Example
Holding BTC at $100,000, selling $110,000 strike call option, receiving $2,000 premium:
| Price at Expiry | Spot P&L | Option P&L | Net |
|---|---|---|---|
| $90,000 | -$10,000 | +$2,000 | -$8,000 |
| $100,000 | $0 | +$2,000 | +$2,000 |
| $105,000 | +$5,000 | +$2,000 | +$7,000 |
| $110,000 | +$10,000 | +$2,000 | +$12,000 |
| $120,000 | +$20,000 | -$8,000 | +$12,000 |
If price rises above $110,000, profit is capped at $12,000. However, you still earn $2,000 premium income if price moves sideways or slightly down.
Choosing Hedging Strategies by Situation
| Situation | Recommended Strategy | Reason |
|---|---|---|
| Confident of short-term decline | Futures short hedge | Low cost, direct protection |
| Decline possible but uncertain | Buy put options | Maintains upside, insurance |
| Expecting sideways | Covered call | Premium income |
| Long-term market neutral | Funding rate arbitrage | Direction-agnostic returns |
| Pre-event protection | Put options or reduce position | Event volatility preparation |
Limitations of Hedging
Cost
All hedging carries costs. Fees, funding rates, option premiums, opportunity costs, etc. Hedging too frequently erodes returns.
Over-Hedging
Hedging all risks eliminates returns too. Full hedging is essentially the same as closing your position. Selectively hedging only key risks is more efficient.
Timing
Starting hedges too late means losses have already occurred. Plan hedging strategies in advance and execute when specific conditions are met.
Correlation Breakdown
When hedging altcoins with BTC futures, correlation is normally high, but can break down in extreme situations. This is the worst-case scenario where hedges don't work as intended.
Summary
Hedging is the most prudent use of derivatives. You can protect directly with futures shorts, protect only the downside while maintaining upside with put options, or pursue direction-agnostic returns with delta neutral strategies. Funding rate arbitrage provides stable returns in persistently positive funding environments but requires understanding the risks. All hedging carries costs, so selectively applying the right strategy for each situation is key.