What Is Hedging In Trading?
Hedging is a risk management strategy that can help traders reduce the risk in their portfolios. It involves opening a trade in the opposite direction of an existing trade to offset the potential loss from the original position. There are various methods that traders can use to hedge their positions, including the use of futures contracts, options, and other financial instruments. Futures contracts, in particular, are often used for hedging because they allow traders to open positions in either direction and leverage those positions to cover all or part of their existing position.
For example, if a trader has a long position in a particular asset and is concerned about the potential for price declines, they can open a short position in a futures contract for that asset as a hedge. This will offset some of the potential losses from the long position, allowing the trader to maintain some or all of their profits if the market moves against them. See Figure 1 below for a visual explanation of hedging:
Delta Neutral
Being delta neutral on the market means that you have no net exposure to changes in the price of an asset. This can be achieved through hedging, which involves taking offsetting positions in the market to cancel out the potential risks and rewards of your existing positions.
For example, if you own 1 Bitcoin (BTC) and want to be delta neutral on BTC, you can open a 1 BTC short position on Drift. This will offset the long position in your wallet and create a delta-neutral position, meaning that you will not experience any profit or loss from changes in the price of BTC. Overall, being delta neutral can be a useful strategy for traders who want to protect their portfolio against market movements or who are uncertain about the direction of future price changes in the near term.
Funding Rate Arbitrage
Hedging can also be used for funding rate arbitrage. Funding rates are fees paid to traders to balance out futures contracts after a predetermined time period. If there are more long positions than short positions at the end of the time period, the funding rate will be positive, and traders with short positions will receive payment for holding their positions. By taking a delta-neutral position (holding spot and being short on futures), traders can effectively take advantage of the funding payments to make a profit, which is a common practice in cryptocurrency markets.
How To Hedge On Drift
- Create a sub-account
First in order to begin hedging on Drift, you will want to create a sub-account (see https://www.drift.trade/learn/dex-sub-accounts for more information on creating a sub-account) to hedge your positions. A sub-account on Drift allows you to open up a new position that is opposite to that on your main account and further isolate the risk.
- Determine the amount you would like to hedge
The decision on how much to hedge is based on the trader's individual trade and risk tolerance and may vary from situation to situation. For demonstration purposes, let's say you have a long exposure of 100 SOL on your main account and your position has gained 10% on the day. To safeguard your profits, you may wish to hedge 50% of your entire position in case the price drops. This will reduce your long exposure from 100 SOL to 50 SOL, minimizing potential losses if the price does indeed fall.
In conclusion, hedging is a risk management strategy that can help traders reduce their exposure to the markets. There are various methods that traders can use to hedge their positions, including futures contracts, options, and other financial instruments. Being delta neutral, or having no net exposure to the price of an asset, can also be achieved through hedging by taking offsetting positions in the market. Additionally, hedging can be used for funding rate arbitrage, which involves taking advantage of funding rates to generate profits.
On Drift, traders can hedge their positions by opening a new subaccount and opening a position that is opposite to the one on their main account. We advise when hedging on Drift to always use the best risk-management procedures.
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