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What is Hedging?

marginfi is a decentralized margin protocol for trading across Solana. The protocol makes it easy for traders to access margin, manage risk, and improve capital efficiency across the entire Solana ecosystem from one unified place.
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This article is a continuation of the marginfi Leverage (learning) series.

Hello Traders! The leverage series is intended to provide a broad overview of key trading concepts. We’ve outlined margin and how it functions and will now move on to key ideas in derivatives. These are the two building blocks you need to understand more complicated trades and how the pieces of them work together.

With that, let’s dive into our first derivatives concept, hedging!

What is Hedging?

A hedge is an investment made with the intention of reducing risk in a portfolio, position, or trade. Hedges are rarely profitable on a net basis but they can greatly mitigate downside risk.

Hedge funds are aptly named for this exact strategy. While many people talk about these funds in the context of their great returns or “beating the market” (RIP L/S), their primary mandate is to not lose money. This is natural when much of your AUM is from pension and government funds that simply cannot afford a large drawdown.

Hedging is not merely for risk-averse investors, however. Many people who have their entire net worth in crypto will contemplate and compose hedging strategies to reduce downside risk because the implications of losses are so large. Warren Buffet famously remarked that the number 1 rule in investing is to not lose money.

A large drawdown can be catastrophic for a portfolio because it requires a greater and greater return to simply break even after a loss. For example, if a portfolio were to fall 50%, it would need a 100% increase to just get back to where it was originally.

Farmers and Quants

Now that we know what hedging is and why it’s important, let’s explore what it looks like in practice. We’ll start with a trivial example and then walk through the most common strategies used today.

Let’s say you’re a banana farmer who sells 5000 bananas a year, one to each member of monkeDAO. You know you will have 5000 to sell but it’s unclear what the price of bananas will be during harvest season. There’s a chance the price rises but you also have a family to feed so you can’t risk the price going down. So what do you do? You take out a futures contract on the price of bananas and lock in today’s price for a few months in the future when you harvest and sell (I know there are no futures contracts on bananas but maybe Cypher will make one if you harass them enough (chart looks good)).

Today the bananas are trading at $1 (these are premium bananas). You take out a contract at that price with monkeDAO and are now committed to selling them for $5000 after harvest. Let’s say there’s a pandemic and the price of premium bananas falls to $.75. If you had not taken out the future, you would have made $1250 less. The contract limited your upside but also removed the downside risk. On the flip side, let’s say there was a huge rise in monkey profile pictures that caused the price of bananas to rise to $1.25. You would make $1250 more if you had not taken out the contract- hence the notion of eliminating upside potential

How to Hedge

Derivatives

Our example is rather simple but there are numerous ways to construct a hedge. The farmer used a derivative (futures) which is the most direct way to hedge. Futures allow for simple price hedging but you can hedge against other factors using options. For example, you could hedge volatility, effects of time, or even the change in the risk-free interest rate. We’ll explore these possibilities in a later piece.

Diversification

While derivatives are a very direct hedge, there are more indirect investing methods that create implicit hedges. A simple example of this is diversification. By exposing your portfolio to multiple assets, you hedge the risk of each one’s performance. This is lesson number 1 in any college finance course or “value investing” (lol) book.

Many prominent figures disagree with this idea, however. Cameron Winklevoss recently tweeted:

This quote was likely ripped from Warren Buffet who has also said:

“Diversification may preserve wealth, but concentration builds wealth”

So how can you limit the diversification in your portfolio while still hedging some underlying risk?

Dollar-Cost Averaging

The answer is dollar-cost averaging or DCA as it is often referred to. DCA is the act of spreading out buys over time. Let’s say I had $10,000 I wanted to invest into SOL. I could send one order to fill the whole amount or I could buy $1,000 a day for the next 10 days. The second option will spread out my price risk over several days rather than locking me in at one price. It’s no guarantee of cheaper entry but it helps spread exposure.

Many people will also DCA with each paycheck (the accumulatoooor). This allows you to spread exposure over a much longer time horizon.

Holding Cash/Stable Coins

Another common hedge is simply holding cash. This de-risks a portfolio by having a percentage of the holdings not move with market prices and also leaves dry powder to buy dips and DCA at opportune times.

Trade-Offs

Hedging is a valuable practice that is crucial to optimal portfolio construction. However, hedges still come with some risks and tradeoffs. The explicit tradeoff is upside. Hedging will limit downside but that comes with the cost of less upside.

Hedging is also risky because there are no guarantees with it. There is no “perfect hedge” just as there is no perfect trade because all of these instruments are subject to the whims of the market. That being said, hedging, like most things in life, should be evaluated through a probabilistic framework and a careful consideration of both the risks and rewards.

Looking Forward

Hedging is one of the key tools to manage risk. While this management is crucial, the practice of hedging contributes to an even larger goal of achieving maximum capital efficiency. We’ll dive deeper into what that means in a future article!

Follow us to stay updated, or join the discord to get the alpha first.

As always, no marginfi content should ever be considered financial advice and no reference to financial assets, securities, derivatives, or other financial products should be considered an endorsement of the aforementioned. Please consult a licensed financial advisor before making any and all investment decisions, and please do your own research.

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Anders

Anders

recovering tradfi enthusiast | building @marginfi