What is hedging?
Hedging, also known as ‘hedging’, is a strategy of avoiding market volatility by locking in asset prices. Simply put, the goal of hedging is to ‘stabilize the situation’ and minimize the impact of price fluctuations on asset value.
Whether you are a long-term holder or a short-term trader, arbitrage can help you manage the risks brought by price fluctuations:
- Long-term holders: When the market is falling, lock in the spot value through hedging to reduce losses.
- Short-term traders: lock in profits in advance through hedging, unaffected by market fluctuations.
Why do we need hedging?
The cryptocurrency market is volatile, with price fluctuations of 10% or more overnight being the norm.
- If you hold a large amount of Bitcoin (BTC), but the market trend is uncertain, you may worry about a price crash.
- At this point, opening a short position (shorting) in the futures market can hedge the downside risk of spot.
The essence of hedging is to put a ‘insurance’ on your investment, especially suitable for users who cannot monitor the market in real time or do not want to take on high volatility risks.
Detailed explanation of hedging operation methods
1. Spot position + open reverse contract position:
If you hold 1 BTC, the current price is 100,000 USDT.
You are worried that the BTC price may fall to 90,000 USDT, so you decide to open a short position of 1 BTC perpetual contract.
If the BTC price really falls, your spot loss is 5,000 USDT, but the contract profit is 5,000 USDT, realizing arbitrage.
2. Locking in Profits in Advance Strategy:
If you buy BTC at a cost of 90,000 USDT and the current price rises to 100,000 USDT.
You can short 1 BTC in the futures market and lock in a profit of about 10,000 USDT (i.e. take profit when BTC reaches $90,000).
Whether the market price goes up or down, your total profit is fixed at around 10,000 USDT.
3. Note on leverage usage:
It is generally recommended to use a 1x leverage for hedging, which can hedge risks without causing liquidation risks due to a high leverage ratio.
What is the funding rate arbitrage?
Funding rate arbitrage is a low-risk investment strategy that leverages the funding rate mechanism of perpetual contracts to earn stable returns from market fluctuations. Simply put, in a trading platform, holding a perpetual contract requires paying or receiving a ‘funding rate’ based on market conditions. By cleverly utilizing this mechanism, investors can achieve risk-free arbitrage.
For example:
When the funding rate is positive (long pays, short receives), you can buy (open long with leverage) spot and open short perpetual contract to earn funding rate.
2. When the funding rate is negative (shorts pay, longs receive), you can sell (leverage short) spot and open long perpetual contracts to earn the funding rate.
How to arbitrage funding rate using contracts?
As shown in the figure below, the funding rate for ETH is positive 0.01%. If we purchase $10,000 worth of ETH and simultaneously open a $10,000 worth of ETH short contract, we will receive a funding fee of $1 at each settlement time (gate settlement time is 00:00, 8:00, 16:00 every day). When dealing with contracts with higher funding fees, we can use arbitrage + funding fee consumption method to obtain funding fees with lower risks. However, users can only profit when the transaction fee is less than the funding fee. The actual income = funding fee - transaction fees (spot purchase fees + contract fees). ClickDetailsYou can check the real-time funding rate of all currencies on Gate.com for reference.
Risk management of hedging and funding rate arbitrage
1. Identify the source of risk:
The risk of hedging lies in the possibility that market fluctuations may result in incomplete hedging losses.
The risk of funding rate arbitrage lies in the fluctuation of the funding rate and the cost of fees.
2. Position Control: Do not use all of your funds for trading. It is recommended to use no more than 30% of your total assets for each transaction.
3. Set up stop loss mechanism:
When hedging, if there is abnormal market volatility in the futures market, you should stop the loss in time.
When arbitrage, if the funding rate return is less than the cost of fees, you should promptly close the position and exit.
Common Questions and Notices
1. Will the funding rate always remain the same?
No, the funding rate is dynamically changing and requires real-time attention to platform announcements.
2. Can high leverage be used for hedging or arbitrage?
• It is not recommended for beginners to use high leverage operations, which carry high risks and may lead to liquidation with a slight mistake.
3. How is the fee calculated?
• Fees will affect actual returns, so calculate them carefully before taking action.
Summary
Hedging and funding rate arbitrage are two practical trading strategies in the futures market:
•Hedging can effectively reduce the risk brought by market volatility, suitable for long-term investors and conservative users.
• Funding rate arbitrage is a low-risk profit strategy suitable for short-term investors or users seeking stable returns.
Through the explanation in this article, I believe you have mastered their basic operation methods. If you want to practice trading, after selecting the appropriate currency, start with small amounts and remember to trade cautiously and be aware of the risks.
