Coinsider's Short to Hedge Guide
During the 2018 bear market, I made the mistake of not hedging my investments. I believed that shorting was too risky so I didn't take the time to learn how to do it. This caused me to hold my coins through a brutal 90% drawdown. However, during the next market cycle, I learned how to short and hedge responsibly. That’s why I’ve been sleeping soundly during this bear market, because my portfolio is properly hedged. In this guide, I’ll teach you how to hedge safely and effectively from start to finish. —Kevin
Please do not proceed with the rest of the guide until you read these disclaimers:
Table of Contents
This guide has three main sections. Feel free to skip around and return to certain elements for reference, but we recommend reading from start to finish to get the complete picture.
Basics of shorting and hedging
Kevin’s personal strategy for hedging
Step-by-step tutorial for hedging on Bybit
What is shorting?
Shorting, going short, or selling short is a technique that investors can use when they expect the price of an asset to go down—they are effectively betting on a price decline. This is different from regular selling in one key regard—you don’t own an asset which you put up for sale. When you short an asset, you borrow the asset and then later pay it back. Shorting is therefore a trading strategy that profits when the price decreases rather than when the price increases. The opposite of going short is called going long, which you do when you expect the price of the asset in question to go up.
Step-by-step process of opening a short:
Borrow (usually from your broker or exchange) asset at price X and immediately sell it at that price.
Wait for the price to drop.
Buy it back at a lower price (price Y) and repay your initial loan.
Your profit is the difference between the price you borrowed & sold it for (X) and the price you rebought it at (Y).
That’s shorting in a nutshell. It is usually achieved through margin trading, which involves borrowing funds. But there are also other trading products available to “go short” that don’t involve the actual buying or selling of any asset directly. For example, you could “open a position” in a derivatives product (such as options or futures), which achieves the same exposure as short selling the actual asset.
Reasons to short
Investors short because they’re betting an asset’s price will drop and they want to benefit from that decrease. But if we want to get more specific…investors and traders go short to:
Speculate on price drops and profit from them. This is usually the most risky form of short selling, and it happens when people day trade or swing trade.
Go “delta neutral.” This is a complex trading strategy that keeps your position value unchanged regardless of if the price goes up or down.
Play the tax game. In some jurisdictions, you may trigger a taxable event when you sell an asset you own and take profits. In such cases, it may be a good alternative to not sell the asset itself, but open a short position to lock in your gains while preventing a taxable event.
Hedge. Investors do this to take a short position to protect our asset’s value.
Shorting to hedge is the main topic we are going to explain in this guide. FYI, other motivations for shorting may require other tactics, strategies, and methods that are not explained here. But today, we’re focused on shorting to hedge.
What is shorting to hedge?
Shorting to hedge is a strategy that is used to protect against potential losses in an investment. It involves taking an offsetting position in an asset that reduces the risk of adverse price movements in the original position. For example, an investor may use a short hedge to protect against the risk of declining asset prices in the future. This is different from speculation, which involves taking positions in order to try to make a profit.
When you short to hedge, the goal is to reduce risk and volatility, rather than to make a profit. You can choose to hedge 100% of your portfolio or only a part of it. But if the amount of hedging exceeds the value of the portfolio, it is no longer considered hedging, but rather speculation or trading.
Why even short to hedge? Aren’t we supposed to HODL?
We do like to HODL! But even if you believe in the HODL approach, shorting to hedge can be a complementary strategy.
As we explain later, shorting to hedge uses derivatives, which means no actual crypto needs to be sold in order to open a short position. The main goal is to protect a part of your long term hold position by taking an offsetting position that goes up in value when prices go down.
Also, even if you are not a strict HODLer, you may still have some of your crypto in cold storage. It may be a hassle to take it all out of cold storage, sell, and then later buy back and put it in cold storage again. A simple short hedge could help investors avoid all that.
Just selling your crypto with the intent to buy it back after the bear market ends might also be risky. No one knows for sure when the bear market ends, so you might end up buying back at a higher price than what you initially sold for. That’s why it might be better to just not sell your spot crypto and instead open and close hedge positions during the bear market. Whatever happens to those positions won’t affect your spot holdings in your portfolio.
When should you short to hedge?
The ideal time to short hedge your portfolio, generally speaking, is during sustained downtrends. Bear markets generally bring such downtrends in prices, which should provide a positive risk:reward ratio for hedging. A positive risk:reward ratio means that you are more likely to make profits than losses. A quick look at the 1 year price chart of Bitcoin, or the overall crypto market cap, should tell you whether we are in a bear or a bull trend.
If the market has a sideways trend after a sustained bull trend, this might also be an appropriate time to start hedging—that’s because a sideways trend may indicate the end of a bull market.
The theoretical risk:reward ratio does get worse closer to the true market bottom, but unfortunately, we can’t know for sure when we’re at the real bottom until well after it’s happened—hindsight is 20/20. Starting hedge positions in the bear market bottom area may lead to a higher total cost of shorting, because there is a higher chance of losses on those positions.
Clear and obvious bear market trend: ideal time to open short hedges. Source: Tradingview.com
But how to identify when a bear market trend begins and when a bear market trend ends? We do not have a definitive answer for that, but we will later share some high level ideas for how we personally estimate the beginning/end of such trends.
When should you NOT short to hedge?
If you don’t properly understand how leveraged derivatives trading products work. They are risky and if you use them incorrectly it can lead to unnecessary losses.
If your intention is to make a lot of profits, shorting to hedge is not the way to go. Short to hedge is only intended to reduce losses and there might be a cost to achieve that.
If you don’t have money that you can afford to lose. The strategies explained in this guide are lower-risk by nature, but there is always the possibility of losing more money than if you didn’t hedge at all. Especially in the learning phase there is a higher chance of your hedge position costing more than the losses it offsets. If you can’t afford that risk, then you should definitely not be experimenting on derivatives platforms.
If the market is trending up. Short positions in an uptrend could cost too much to keep open, relative to the protection it provides.
During bull trends it is best to avoid short hedging, because the cost of losses does not justify any protection that it could provide. Source: Tradingview.com
What methods for hedging are available?
This is by far the most popular form of leveraged trading, because of the high leverage offered (usually up to 100x). These are derivative contracts, so there is no spot trading involved. Prices are usually close to market prices, which makes it easy to understand. There are no expiration dates for these contracts. They have a funding rate in which either the shorts pay the longs or the longs pay the shorts, depending on which side has more demand. Perpetual contracts are what we will focus on in this guide.
Shorting via margin trading
This is where you borrow the actual asset (from the exchange) and then sell it on the spot market. It generally allows less leverage compared to other methods of hedging. If you don’t want to sell your crypto to open a hedge, this is not for you.
Futures contracts are similar to perpetuals but they DO have an expiration date. They have no funding rate, so it is “free” to have a position open. On the expiration date, the contract will settle for whoever holds it on that date, so a profit or loss will be realized then.
Buying put options means you make profit when the price of the underlying asset goes down. This means you could hedge by buying put options too. Due to volatility in crypto markets, those premiums are usually too high to make them worth it for hedging purposes.
From all available methods to hedge, this guide will solely focus on short hedging through perpetual contracts, because those are the most straightforward and flexible to use. Plus, the liquidity for perpetual contracts is often better than for other products.
Costs of a hedge
In order to determine if it makes economic sense to open a short hedge position, it is vital to understand the costs associated with it. Hedging is NOT free and it’s certainly not perfect as a protection mechanism.
The most important cost components for perpetual contracts to be aware of:
Trading fees: Each time you open or close a position (and when you liquidate) you pay a fee for your entire position. That means that opening or closing a ton of positions will increase your total cost of hedging. For hedging purposes, fewer transactions are more cost effective.
Funding rate: This is the fee you pay periodically as long as you have a position open. Shorts pay longs when there is higher demand for shorts, and longs pay shorts when there is higher demand for longs. The purpose of this system is to keep the perpetual contract price as close to the underlying asset price as possible. During bear markets, there is often higher demand for shorts than for longs, which means we will be paying a periodic funding fee to traders who have long positions open, in order to keep our short hedge position open.
Cost of liquidation/getting stopped out: Each time you get liquidated or your stop loss order executes, your realized loss will add to the cost of hedging. Ideally we want to avoid getting liquidated or stopped out for that reason. This usually makes up the largest component of the total cost of your hedging strategy.
Risks of hedging
Hedging is not a perfect strategy and there is the possibility of losses. So when you approach hedging, you should think of it in terms of its pros and cons. Ask yourself: Does the benefit of hedging outweigh the cost that it requires? If the answer is yes, then it’s a good idea to proceed with hedging. Don’t forget though, a successful hedge is one that prevents losses, it’s not meant to make you profits.
Major concepts and definitions of derivatives platforms:
On most derivatives platforms, the same concepts and definitions apply for trading perpetual contracts, which we will summarize here.
Remember, you are not borrowing and selling the actual assets. Perpetual contracts are designed to act the same as the real asset (in terms of following the price as closely as possible), but they are mostly cash-settled contracts. At no point is any real BTC or ETH involved. Another important difference is that you will pay or receive the funding rate as long as your position is open. There are a lot of ways to customize your risk and reward profile because you can choose from 1 to 100x leverage.
Funding fee: this is the fee that you will pay periodically as long as the position is open. On most exchanges this is every 8 hours. Be aware of how your specific platform deducts this. Usually this is deducted from your margin every 8 hours until the maintenance margin is reached. After this you would need to add more margin or the position will be automatically closed.
Open/close, buy/sell, short/long. Because you are not actually buying or selling anything with perpetual contracts, the correct terminology is therefore “opening” and “closing” a position. For short hedging we use “sell short” to open a position. When closing a position, we would “close short”.
Margin, isolated margin, cross margin.
Margin is the amount that is reserved from your total balance to open a position. The higher the leverage, the lower the margin is required to reach the same total position size. The lower the leverage, the higher the margin is required to get the same position size.
Subsequently, the higher the leverage, the closer the liquidation price is to your initial opening price, and thus you have a higher probability to be liquidated (and lose your margin).
Isolated margin means that a specific amount from your account funds is reserved for the position you want to open. If the position gets liquidated, only this reserved margin amount will be lost. The rest of your funds will not be affected.
Cross margin means that your entire account balance (minus existing isolated margin) can be used as margin for your position. The risk of losing your entire account balance is possible with cross margin positions, especially during times of sudden and extreme volatility.
For selling/shorting: the minimum price you want to execute your order at. Anything lower and the order will not execute and will remain in the order book until the market price reaches your limit price.
Market order: your order will be executed at the best available price in the order book.
Limit orders are recommended in three situations:
In low liquidity markets where high slippage can occur
When very precise order prices are needed for your strategy
When you’re setting take profit orders
Market orders in high liquidity markets will usually execute the fastest and at a price that’s reasonably close to the market price.
If we’re short hedging assets with high liquidity, market orders are often better than limit orders because they execute quickly and you won’t risk a missed opportunity if your order doesn’t execute.
Maker and taker fees
Maker fee is the transaction fee when you place a limit order that actually lands in the order book. Limit orders can however be executed immediately if the market price is better than your limit order price, in which case you would pay the “taker fee.”
The taker fee is the transaction fee that you pay when you place a market order (this fee is usually higher than the maker fee).
For short hedging highly liquid assets such as BTC and ETH perps, there is not much benefit to using limit orders. So for most users, using market orders and paying taker fees makes more sense.
Position size: This is the total USD or crypto amount (i.e. $20,000 or 1 BTC) that you are shorting or longing. This is roughly your margin multiplied by your leverage.
Leverage: This is usually expressed as a ratio or multiplier (i.e 5:1 or 5x). This tells you how large your position size can be with a certain amount of margin. Your leverage also affects your liquidation price: the price where your position gets closed automatically to prevent further losses that are not collateralized.
Stop Loss: the price you set on your position where if the price goes against you past that price, an order will be triggered to close the position and cut further losses. If we base our maximum loss on the liquidation price, then setting a stop loss may not be strictly necessary. However, if a stop loss is not entered, you may need to monitor your position more actively and decide to cut losses manually.
Take profit price: the price you set at which an automated order is sent to close your position to take profits. If you have a predetermined plan where you want to exit your short hedge, a take profit order may help you do this automatically.
Example of choosing position size and leverage for your hedge:
An important part of constructing your order is deciding the position size and the leverage. This is, however, more of an art than a science and depends on a lot of factors. This section will only discuss the relationship between the two and how to properly calculate your position size and leverage based on how much you want to hedge and how much risk you are willing to take.
Say you have 1 BTC at a price of $20k per BTC. If you want to short hedge 100% of that with 1x leverage, then you will need a minimum margin of $20k. The liquidation price will be 100% above the entry price, so if the price of BTC goes to $40k, your position will be liquidated and you will lose your initial margin of $20k.
You may decide not to hedge your full BTC and instead hedge 50% of it with 1x leverage. Your position size would therefore be 0.5 BTC and the margin $10k. Your liquidation price will still be $40k, but if liquidated, you only lose your $10k margin. On the other hand, if BTC falls to $0, you would profit $10k. But that would only offset 50% of your loss of $20k on the 1 BTC that you were hedging.
You could also decide to hedge 50% of your 1 BTC, but with 2x leverage. Now your position size is still 0.5 BTC, but your margin is only $5k. Your liquidation price would be 50% above the current price, so $30k. That means you would lose $5k if you get liquidated, but your max profit if BTC hits $0 would be $10k, offsetting 50% of your loss on your 1 BTC.
Important numbers to remember when calculating position size, leverage, and deciding where your liquidation level should be:
1x leverage will let the price go 100% against you from the entry price before liquidation occurs, but you will need 100% of your position size as margin.
2x leverage will let the price go 50% against you from the entry price before liquidation occurs, but you will need 50% of your position size as margin.
3x leverage will let the price go 33.33% against you from the entry price before liquidation occurs, but you will need 33.33% of your position size as margin.
This is Kevin’s personal hedging strategy. It is not perfect nor foolproof by any stretch. It may also change in the future. This section should only be considered an example.
On hedging vs. swing trading:
It’s important to remind ourselves constantly that we are hedging, NOT swing trading. That means we need to make sure that we don’t get tempted to go long, because that defeats the purpose of hedging. For example, if you think “oh, the bottom must be in, time to go long!” and then the price moves down more? You’d end up losing more money doing that, and you wouldn’t be hedging anymore.
When I’d start hedging:
The perfect time is at the top of the bull market. But since we can’t know that for sure, here are several things I personally look for before I start hedging:
Several consecutive months of a downtrend in prices.
After a parabolic blow off top. But this doesn’t always come, as we’ve seen in this past cycle.
When some technical indicators flash warning signs. For example, when Bitcoin’s price drops below its 100-day moving average. That is just one example and you’ll have to learn technical or on-chain analysis to decide for yourself which indicators you want to follow.
When something major changes in the market. Like when the Fed starts to raise rates, if a big crypto company collapses, etc.
When I’d stop hedging:
There are two approaches for when to stop hedging—you can choose your own based on your own personal goals. The first approach is that prices have dropped low enough to a point where you are happy to just close your shorts, and you take that profit to scoop up some coins for long term holds. It needs to be at a price that you are comfortable with, because prices could drop even more, in which case you’d need to be mentally ready to hold and not panic.
The second approach is you don’t stop hedging, and you continue your hedge until you are confident that we are back in a bull trend. Once again, you’ll have to make your own judgment call on that based on various metrics, charts, etc. With this approach, you may lose your initial hedging capital, but that may be okay because the value of your spot holdings will be higher, too.
How much capital to hedge with:
I personally like to hedge with a small percentage of my overall portfolio, i.e. risk 10% of my overall portfolio to open a hedge position. That would NOT cover my entire portfolio value, but that’s ok with me, because I don’t want to risk that much for my hedge.
How much leverage to use:
Definitely start with 1x leverage (aka no leverage) at the beginning. Get comfortable with that for several weeks or months, before starting to use higher leverage. I personally decide the amount of leverage I use based on how much downward volatility I’m expecting in the near future. For example, if price action is pretty sideways and calm, I may open a 3x leverage position in anticipation of a big move. After the move happens, I close that position and re-open a new one with 1x or 2x leverage, because prices usually tend to bounce. On the other hand, if the price moves against me in a big move, I also close my 3x leverage position and open up a new position with 1 or 2x leverage so that I can wait and see how price action develops and re-evaluate.
This is my personal strategy currently and I may change it in the future if I find something else that works better for me. But I highly recommend that you do not go over 3x leverage for hedging purposes. If you go higher, it’s too easy to get liquidated, and that defeats the purpose of hedging
Which assets should we short?
I stick with the majors, BTC and ETH. They are good at representing the overall crypto market. I don’t short illiquid or smaller crypto coins as they are way too volatile and easier to manipulate. It can easily stop out or liquidate your short, even if you are right about the general direction.
On stop losses:
I usually don’t set stop losses and I just check my position multiple times a day, especially when I get a notification of a sharp move. If things move for or against my position, I can then close them and re-open new positions, while adjusting my parameters.
You can choose to set stop loss orders, but keep in mind that they may be detrimental to your hedging strategy if they execute and keep you out of a position while a sharp move happens. Also, a stop loss may not be necessary given that your position’s liquidation level serves as a stop loss in and of itself.
How often should we check on our positions:
At least once a day, but I usually check twice a day. Especially when I get a notification on my phone of a big move, I like to log in and check the position. I check to see the profit/loss amount, how close my position is to the liquidation level, how the funding fee is affecting my position, etc.
When to open/close positions:
After a big move in either direction, I like to close my positions and reopen them with adjusted leverage (as mentioned in the leverage section above). Sometimes if one coin looks “weaker” to me, based on certain technical or fundamental indicators that I personally follow, then I may close a position for Coin A and open a new short position for the weaker looking Coin B.
On funding rate fees:
I generally don’t worry about this too much and consider it a cost of keeping my hedge open. Big moves can happen at any time so I don’t want to be sidelined and out of a hedge position. Also, because I am using less leverage, deducting the funding fee from my margin or available balance shouldn’t put my position at risk that easily. But make sure to check that your account balance or margin has enough to cover the funding fees, because when the funding fee rate is high, your balance could be drained faster than you initially expected.
In this segment we will walk you through an example of how to short to hedge on Bybit. For explanations about other order varieties or general explanations, please refer to the previous segment titled “General principles on derivatives platforms.”
If you don’t have a Bybit account, please sign up using our affiliate link to support us: https://partner.bybit.com/b/joincoinsider
Opening a Short Position (Sell Short)
Click on the “Cross 10.00x 10.00x” tab. A popup window will open
Select “Isolated Margin” in the popup window
These will be the new default values for your order form. But always check with each order if the settings are still correct for the specific order you want to place.
In terms of funding fee and margin amount, the following from Bybit is important to understand when using Isolated Margin:
“When a trader pays funding fee for a position, the funding fee will be deducted from the available balance at every funding timing (0000 UTC, 0800 UTC and 1600 UTC). In the event where a trader has insufficient available balance, the funding fee will then be deducted from position margin and this will result in the position's liquidation price to move closer to the mark price and increase the risk of liquidation.”
This means that besides the margin amount that will be locked for opening the position, your Derivatives Account balance needs to have enough “Available Balance” to pay for the funding fee every eight hours. If the “Available Balance” is not enough, the funding fee will be deducted from the position margin and result in the liquidation price moving “closer to the mark price and increasing the risk of liquidation.” So make sure the Available Balance is sufficient to avoid having your funding fee deducted from your position margin.
Click on “Order by Qty”
A popup screen will appear: select “Order by CostUSDT” and confirm.
The order form will now display “Order by Cost”
Now enter the total order size in USDT that you had calculated. As explained in the screenshot, this cost also includes the fees for opening and closing your position. Keep in mind that the order cost is the total order size and not just the margin.
(We will not go into the details for setting Stop Loss and Take Profit levels. Please refer to the “General Strategy” section for more tips on if/when to use these features.)
Close an open position to take profit (or cut losses)
For this we can use the same order form, but we need to make sure that we use the same parameters that we used for opening the Short position.
Check the parameters such as “Isolated” and leverage
Choose “Close” in the form
Click “100%” if we want to close the entire position (or manually fill in the quantity).
Click “Close Short”
Alternatively, you can scroll down to the bottom of the screen, where it says “Positions” and lists all your open positions. You can select your open position and close the order from there.
Need additional help?
I hope you find this comprehensive guide helpful. If there are any questions you have at all, please contact Kevin at [email protected]. Your questions will help us tweak and improve this guide for other readers as well. Also please join our Telegram community if you want to chat with our broader community about hedging strategy in general.