Oh, the Volatility Outside is So Frightful. Is Hedging So Delightful?

Today’s “Long Story Short” discusses the mechanics of hedging or scaling your market exposure using a bitcoin perpetual swap. Kollider’s…

Oh, the Volatility Outside is So Frightful. Is Hedging So Delightful?

Today’s “Long Story Short” discusses the mechanics of hedging or scaling your market exposure using a bitcoin perpetual swap. Kollider’s educational series is not a basis for making investment decisions, nor can it be interpreted as a recommendation to engage in any investment transactions. Please do your own research.

It’s a habit for many people to wrap up work projects before heading off to family for the holiday season. For those of us in the bitcoin world, the end of the year marks a new tradition: profound volatility. Regardless of whether bitcoin prices rise or fall, you can easily protect (or even profit from) your bitcoin holdings by hedging.

We’ve discussed perpetual swaps in our previous articles and even skimmed over hedging, but we haven’t explained the process thoroughly. Today, we’ll explore bitcoin perpetual swaps and see how they can protect or increase your portfolio’s exposure to price swings over the coming months.

Oh, is the Volatility Frightful?

Does volatility necessarily accompany the end of the year? One year ago, bitcoin surged from ~$19,000 in December to ~$40,000 in early January, a 110% increase, only to drop to ~$30,000 three weeks later. January prices were ~$7000 the year before that. By February, they rose by 42% to ~$10,000. A year earlier, prices dropped more than 50% into December. Bitcoin soared 215% to around ~$19,000 before plummeting back down to under ~$7,000 for a 65% drop.

And since November this year, we’ve watched bitcoin prices drop 28% from ~$67,000 down to the current ~$48,000. What will the next few months look like? Well, for you that could be smoother sailing.

Some of the biggest price surges and drops tend to occur around this time, so we want to make sure you’re prepared. To do that, you must first understand what an inverse perpetual swap is.

Bitcoin Inverse Perpetual Swap?

Our primary goal here is to help you learn important concepts as easily as possible. So, we’ll only cover what’s salient to you right now about inverse swaps, and we are only specifically going to talk about BTCUSD.

For our purposes today, we only care that these bitcoin inverse contracts:

  1. Let us use bitcoin instead of US dollars as margin.
  2. Denominate the contracts in US dollars.
  3. Give us prices as BTC/USD (the dollar cost of 1 bitcoin).
  4. Keep it as close to BTC/USD spot prices as much as possible.

For more details on the background of the bitcoin perpetual swap, you can read the creation of the bitcoin perpetual swap.

It is important to note that these contracts are different from the “linear” contracts. Please keep in mind that anything we discuss here will not apply to linear perpetuals or futures.

How to Hedge With the Bitcoin Perpetual

When we talk about hedging, what we’re really talking about is controlling your “bitcoin exposure”. For today, let’s call this your exposure “factor”. In other words, if you own any bitcoin, you have a scaling factor of 1. That is, the value of your bitcoin will move one-to-one with the bitcoin market prices.

Some might note that the “factor” here sounds a lot like “delta”, but strictly-speaking, these inverse perpetual contracts are all delta one products, and we want to talk specifically about scaling our bitcoin portfolio’s US dollar value relative to the original bitcoin amount we had.

As a result, if bitcoin prices double, and you have a factor of 1, the value of your holdings will also double. Alternatively, if the scaling factor were 2, your holdings’ value would have quadrupled. But we’ll cover factors greater than 1 later, so you can ignore that for now.

When hedging against volatility, we want a factor of 0, which is sometimes called “delta neutral” or “market neutral”. Because we already own bitcoin, all we need to do is figure out the equivalent of -1 in bitcoin perpetual contracts. With inverse swaps, this turns out to be rather straightforward.

For hedging, we take a short position on these contracts and there are just two things to consider:

  1. Contract Size. Exchanges typically have each contract represent $1 or $10.
  2. Price of Contract. The price we sell at will determine just how many contracts we need.

Assuming you are trying to hedge your entire bitcoin holding, then the formula is simple.

Contracts_To_Sell = (BTC_Amount x Price_of_Contract) / Contract_Size_USD

For example, let’s say you have 2 BTC and the markets are suggesting that you could sell perpetual swaps of size $1 at $50,000. Then, to perfectly hedge, you would need to sell:

(2 BTC x $50,000) / $1 = 100,000 swap contracts

Also, modifications are easy. You can use the same formula to hedge just some of your holdings. Suppose you want 1 BTC to still be exposed to the changes in bitcoin spot prices and the other 1 BTC to be delta neutral, then just use 1 BTC for the BTC_Amount in the formula. If the contract sizes were instead $10, then using the formula would show that you need a tenth of the perpetual contracts to hedge.

Mechanically, the actual hedging requires you to move bitcoin as margin into an exchange that lists the bitcoin perpetual product, like Kollider. Then, you can follow the same formula above and put in a sell order for the number of contracts you require at the price you can get at that time. Technically, you don’t need to put the entire amount of bitcoin that you want to hedge into the exchange as margin, but there are very important things to consider when you take more than 1x for leverage that we are not covering today.

What If You Want Exposure to Volatility?

With the potential for large price movements, maybe you actually want to be exposed to the price volatility. Perhaps you have a pretty strong opinion that prices might surge or crash and want to actually take a direction.

Here, factors < 0 and > 1 come in handy. A factor of 2 means we gain double if the bitcoin prices go up and lose twice as much if it goes down (and a factor of 3 triples it). A factor of -1 means that when BTCUSD goes up and doubles in prices, our bitcoin holdings’ value would be half in USD (and if prices tripled, our holdings would be a third in USD).

We need to add our scaling factor into the original formula.

Number_of_Contracts = (Factor — 1) x (BTC_Amount x Price_of_Contract) / Contract_Size_USD

For example, if you already own 1 bitcoin and want to know what to buy and sell in contracts (say, currently at $50,000) in order to double your exposure (i.e., factor of 2), we calculate the following:

(2–1) x (1 BTC x $50,000) / $1 = +50,000 contracts

You have to buy 50,000 contracts. This makes sense since this gives you the equivalent of an additional bitcoin. With your 1 BTC spot holding, your bitcoin portfolio’s value is now 2 BTC.

If we wanted to reverse our position’s value against bitcoin prices (i.e. a factor of -1), the formula above would get -100,000 contracts. This also makes sense since selling 100,000 perpetual swap contracts at the price of $50,000 gives us the equivalent of selling 2 BTC, so with our 1 BTC spot, we now have a bitcoin portfolio value of -1 BTC. Note that the sign of the Number_of_Contracts determines whether we buy or sell. Positive tells us to buy and negative tells us to sell.

Oh, How Delightful

This can easily branch into many other exciting topics. Astute readers may notice for example that the hedging above sounds fairly similar to the spread trading that we discussed before. In fact, this “basis trade” is a popular strategy, and it accounts for a large portion of liquidity and volume in the crypto market.

In addition, for those that have read about the efficiency of the Lightning Network for algorithmic trading, you might wonder how Lightning could be handy. Turns out, Lightning is also quite useful for someone looking to hedge their bitcoin positions, especially when paired with features like Kollider’s order-by-order settlement that lets you minimise bitcoin custody risk. Aside from Kollider, other exchanges have integrated with Lightning, and we believe the list of feature improvements will just keep growing.

These next few months might be rocky, but you now have the tools in order to protect or profit from your bitcoin. However, please be aware that we are omitting some factors from this article, such as leverage and liquidations, that start to play an important role once you go outside the 0 to 1 factor range. Similarly, there are other dimensions to consider with inverse perpetual swap contracts like funding, but those are lessons for another day.

In the meantime, best wishes, hang tight, and enjoy the ride!

Know anyone else interested in learning about bitcoin, Lightning, and trading? Follow us on Twitter and help us share the word.