Hedging in Crypto Yield Farming: Manage Risk Smartly

Investing in crypto without taking precautions against losses is like riding a bike without brakes. It is important to take the right precautions to ensure the safety of your funds, and your mental health by extension.

Today, we are talking about Hedging - a type of brake that can protect you even in extreme market conditions when used correctly.

In this blog, we will look into the following topics:

• What is Hedging

• Advantages and Disadvantages of Hedging

• Hedging in Crypto Yield Farming

What is Hedging?

Hedging is a risk management strategy used to protect your investment from potential losses. For example, health insurance is a hedge against medical expenditures.

For example, an investor buys a share of XYZ as a long-term investment; to protect his funds from market volatility, he shorts options. This way, if the stock price drops, the losses are protected by the strike price.

However, please note that hedging doesn't work in all situations, it requires a good sense of timing and understanding of market conditions to execute a good hedge.

When adventurers prefer to live on the edge, can you guess what crypto bros prefer to live on - the Hedge! 😁

Advantages and Disadvantages of Hedging

Advantages:

• Risk Reduction: Protects against sudden market movements.

• Stable Returns: Helps maintain a consistent yield, even in volatile conditions.

• Diversification: Allows traders to spread risk across multiple assets or strategies.

Disadvantages:

• Reduced Profit Potential: Since hedging mitigates risk, it may also limit potential gains.

• Complexity: Requires an understanding of financial instruments and trading strategies.

• Additional Costs: Can involve extra fees, such as funding rates or transaction costs.

Hedging in Crypto Yield Farming

Hedging is widely used in crypto yield farming to protect against price fluctuations while ensuring stable returns. Now that you've understood hedging, let’s look at two common strategies that share the same concept as hedging - Contango Arbitrage and Spot-Perpetual Arbitrage. We have time-tested these strategies to verify their consistency and effectiveness, check our docs for more.

1. Contango Arbitrage

Contango Arbitrage takes advantage of price differences between the spot market and the futures market, where futures prices trade higher than spot prices. A hedging strategy in this case involves:

• Buying the asset in the spot market.

• Selling an equivalent amount in the futures market.

  This ensures that price fluctuations do not impact the overall profit, allowing traders to lock in a predictable yield.

Example: Suppose Bitcoin is trading at $40,000 in the spot market, while a three-month BTC futures contract is priced at $42,000. A trader buys 1 BTC in the spot market and simultaneously sells a futures contract for 1 BTC at $42,000. When the contract expires, the price difference locks in a $2,000 risk-free profit, minus trading fees.

2. Spot-Perpetual Arbitrage

This strategy exploits the funding rate mechanism in perpetual futures contracts. A hedged position involves:

• Holding a long position in the spot market.

• Taking a short position in the perpetual futures market.

  When funding rates are positive, traders receive payments for holding the short position, generating a steady return while eliminating exposure to price movements.

Example: Assume ETH is trading at $2,000 in the spot market, and the funding rate for ETH perpetual futures is 0.05% per 8 hours. A trader buys 10 ETH in the spot market and takes a short position in ETH perpetual futures for the same amount. If the funding rate remains positive, the trader continuously earns 0.05% of the position value every 8 hours while remaining hedged against ETH price movements.

Conclusion

Hedging is a valuable tool for DeFi investors aiming to optimise their yield while managing risk. Remember that factors such as liquidity constraints and execution costs must be carefully considered to ensure profitability. However, if you want a tool to help you automate your yield generation, meet Multipli!

Multipli is a yield-generating platform that employs Contango and Spot-Perpetual Arbitrage strategies to generate consistently high yields on your RWAs. We do the work for you! Try out our platform now.