Trading Strategies for Futures Contracts: Short vs Long Hedge

There are two fundamental hedging strategies for crypto futures contracts: short hedge and long hedge. Learn how to use both as a trading strategy.

Crypto futures contracts are an advanced tool for crypto traders. Learn how to trade crypto with both long and short hedges.

Key Takeaways:

• There are two fundamental hedging strategies for crypto futures contracts: short hedge and long hedge.
• A short hedge is a hedging strategy that involves a short position in crypto futures contracts. It can help mitigate the risk of a declining asset price in the future.
• A long hedge is a hedging strategy that involves a long position in crypto futures contracts. It can help mitigate the risk of a rising asset price in the future.
• Perpetual contracts are derivative contracts similar to futures, except they have no expiry or settlement date. They are particularly popular in the crypto space.
• Learn about strategies for mitigating basis risk below.

Hedging in Crypto Futures

There are two fundamental hedging strategies using crypto futures contracts; namely, short hedge and long hedge.

What Is a Short Hedge?

A short hedge is a hedging strategy that involves a short position in futures contracts. It can help mitigate the risk of a declining asset price in the future. Market participants and firms usually use this strategy for the assets they sell.

Here is an overview of a short hedge:

In the example above, on 15 January, an oil producer enacts a contract to sell 1 million barrels of crude oil, and the sale price is the market price on 15 July. The oil producer will gain $1 million for an increase of $1 in the oil price over the following six-month period, and lose $1 million for a decrease of $1 in the price during the same period.

Meanwhile, the crude oil futures price for July delivery is $100 per barrel. As hedge ratio equals value at risk divided by notional value, in this case, it equals ($100 × 1 million/($100 per barrel x 1,000 contracts) = 1,000 contracts. The company can effectively hedge its market exposure by shorting 1,000 futures contracts. If the oil producer closes out its position on 15 July, the intended effect is to lock in a price close to $100 per barrel; hence, $100 million in total.

Case 1: Suppose that the spot price on 15 July turns out to be $102 per barrel. The company realises $102 million (= $102 x 1 million) for the oil under its sales contract. The price of the futures contract should be very close to the spot price of $102 on the expiry date; for simplicity, we shall assume they are exactly the same. The company, therefore, loses $102 – $100 = $2 per futures contract and $2 million on the futures position in total. As a whole, the company realises a revenue of $(102 – 2) million = $100 million.

Case 2: Alternatively, suppose the spot price on 15 July turns out to be $96 per barrel. The company realises $96 million for the oil under its sales contract. It gains $100 – $96 = $4 per futures contract and $4 million on the futures position in total. Again, the company realises a revenue of $(96 + 4) million = $100 million.

We can thus see that the short hedge helps lock in the revenue at $100 million with futures regardless of the price changes.

What Is a Long Hedge?

A long hedge is a hedging strategy that involves a long position in futures contracts. It can help mitigate the risk of a rising asset price in the future. Market participants and firms usually use this strategy for the assets they plan to buy.

Here is an overview of a long hedge:

Suppose that on 15 January a manufacturer agrees to provide 100,000 tons of steel on 15 July. On 15 January, the spot price of steel is $630 per ton, and the futures price for July delivery is $600 per ton. The manufacturer can hedge its position by taking a long position in futures contracts and closing its position on 15 July. Each contract is for the delivery of 100 tons of steel. The intended effect is to lock in the price of the steel at $600 per ton and $60 million in total.

Case 1: Suppose that the purchase cost turns out to be $660 per ton. The futures price converges to the spot price on the expiry date; for simplicity, we assume they are the same on the expiry date. The manufacturer then gains $(660 – 600) × 100,000 = $6 million on the futures position. The purchase cost of the steel is $660 × 100,000 = $66 million. Thus, the net cost equals $(66 – 6) million = $60 million.

Case 2: Suppose the purchase cost turns out to be $520 per ton. The manufacturer then loses $(600 – 520) × 100,000 = $8 million on the futures position. The purchase cost of the steel is $520 × 100,000 = $52 million. Thus, the net cost equals $(52 + 8) million = $60 million.

In both examples, for simplicity, we have assumed that there is no daily settlement. With daily settlement, the payoff from the futures contract is realised day by day throughout its life. It can slightly impact the performance of a hedge in practise.

Basis Risk in Crypto Futures Contracts

The above examples are all perfect hedges eliminating uncertainty in the futures prices; but in practise, hedging also involves an inherent risk known as basis risk. It refers to the difference between the spot price of the asset to be hedged and the price of the futures contract used.

If the asset to be hedged and the underlying futures contract asset are equivalent, the basis equals zero at the expiration of the futures contract. Prior to expiration, the basis can be positive or negative, and changes in basis can improve or worsen a hedger’s position. An increase in the basis is known as a strengthening of the basis; while a decrease in the basis is known as a weakening of the basis. 

Basis Risk for Long and Short Hedges

In the case of a short hedge, the hedger’s position improves with an unexpected strengthening of the basis because the hedger earns a higher price for the asset after considering gains or losses from the futures contract. Following the same rationale, the hedger’s position worsens with an unexpected weakening of the basis.

In the case of a long hedge, the opposite holds. An unexpected strengthening of the basis worsens the hedger’s position since the hedger needs to pay a higher price for the asset after considering gains or losses from the futures contract. If the basis weakens unexpectedly, the hedger’s position improves.

Basis risk generally increases with the time difference between the hedge expiration and the delivery month. A practical rule of thumb to mitigate basis risk is to pick a delivery month that is as close as possible to, but later than, the expiration of the hedge. Assume the delivery months for a futures contract on a particular asset are March, June, and September. For hedge expirations in December, January, and February, the March contract is the best choice for mitigating basis risk.

Crypto Futures vs Crypto Options

Both crypto futures and options are common derivatives used in trading, but they have different properties. Here we go over some of their prominent differences. For further reading, visit our articles on option basics and option strategies for a deeper understanding of their uses and trading strategies.

Rights or Obligations

Futures are legally binding contracts that require both buyers and sellers to respectively purchase and deliver the underlying assets according to the terms. As for options, the buyer has the right to buy (call option) or sell (put option) the underlying asset, and it is not a must for the buyer to exercise the right. The option seller must act according to the buyer’s decision.

Potential Gain or Loss

For both buying and selling a futures contract, the potential gain or loss is theoretically unlimited. On the other hand, the payoff structure of options is ‘asymmetrical’. For buyers, the potential gain is unlimited, while the maximum loss is limited to the premium paid. For sellers, the maximum gain is limited to the premium received, while the potential loss is unlimited.

Premium Cost and Margin Requirement

When opening a futures position, users need to pay a margin deposit irrespective of whether they buy or sell a contract. For options, the buyer pays the premium when the contract starts and does not have to post a margin; only the option seller must pay a margin.

Perpetual Contracts

Perpetual contracts are derivative contracts similar to traditional futures, except they have no expiry or settlement date. They are particularly popular in the cryptocurrency space, as they allow traders to hold leveraged positions without the burden of an expiration date.

Thanks to their ‘funding rates’ mechanism, perpetual contracts also trade closer to the index price of the underlying asset, compared to traditional futures.

The index price is the average spot price of the underlying asset across multiple exchanges. A funding rate is the sum of two main parts: the interest rate and the premium. The interest rate component is usually constant, and it depends on the interest rates for borrowing the assets specified in the contract. The premium component is the difference between the perpetual price and the mark price, which is derived from the index price.

If the funding rate is positive, longs pay shorts. If it is negative, shorts pay longs. The total amount of funding involved is calculated as follows:

Funding = Position Value × Funding Rate

Funding rates motivate traders to buy perpetual contracts when the contract price is lower than the index price and sell when the contract price is higher than the index. As a result, the price of the contract closely tracks the underlying asset price. The Crypto.com Futures Contract Trading FAQs provide more details on how users can conduct margin trading activities with futures contracts.

Traders using perpetual contracts should be aware of the tick value of the futures contract they are trading and the usual tick movements of the contract. These would significantly impact the profit and loss, as well as the corresponding volatility of their futures position.

Crypto Futures and Other Advanced Trading

In addition to learning some of the basics of trading futures contracts, check out the basics of an exchange for details on the functions of cryptocurrency exchanges, how they operate, and what types of orders and trades users can execute.

Due Diligence and Do Your Own Research

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