On 18 July, Jacob Canfield, a prominent figure in the cryptocurrency world, shared valuable insights on the concept of hedging via the social media platform X. Canfield emphasized the importance of hedging as a strategy for traders to protect their investments against market downturns and manage capital gains effectively.
Canfield started by explaining that hedging is one of the best methods to safeguard investments from downside risks. He said that it also helps traders avoid selling assets within a year, which can lead to significant capital gains taxes. He then listed several reasons for hedging:
- Reducing Taxable Events: By hedging, traders can avoid premature sales that would trigger short-term capital gains taxes, which are typically higher.
- Locking in Notional Profit: Traders can secure the current value of their investments without selling them, which is particularly useful in volatile markets.
- Protecting from Downside: Taking an offsetting position helps mitigate potential losses if the market moves against the primary investment.
- Taking Advantage of High Funding Rates: In euphoric market conditions, hedging can also generate additional profits through funding rate arbitrage.
- Navigating Mania/Euphoria: Hedging is essential during market bubbles to reduce exposure to sudden corrections.
Canfield defined hedging as using a secondary market to take a position that is equal and opposite to the original investment. This approach reduces risk, ensuring that any loss in one position is offset by a gain in the other. He also highlighted that leverage should primarily be used to reduce counterparty risk, not for speculative gambling.
To illustrate the concept, Canfield provided a practical example involving Solana (SOL). Suppose a trader buys $50,000 worth of Solana at $10 per coin. If Solana’s price rises to $200, the investment’s value increases to $1,000,000. However, selling within a year would incur a 37% capital gains tax.
Instead of selling, the trader can hedge by shorting $1,000,000 worth of Solana using a derivatives or futures market with 10x leverage, resulting in a $100,000 position size in a SOLUSDT.P contract on platforms like Bybit or Binance. This means if Solana’s price continues to rise, the trader does not lose money, and if the price falls, the losses are offset by gains in the short position.
Canfield also noted that during euphoric markets, where funding rates are high, holding a short position can be profitable due to positive funding rates paid to shorts, a strategy known as funding rate arbitrage.
Canfield emphasized that hedging requires traders to be comfortable with the possibility of price movements against their spot position, as it involves locking in value and anticipating market corrections. Beginners can start with simple hedging strategies, while more advanced methods involve options and dated futures contracts.
Featured Image via Pixabay