One area of the cryptocurrency space that’s blown up over recent years is derivatives. BitMEX was the first to market back in 2014, with its range of futures and perpetual swaps. Institutional player CME entered the game at the end of 2017. Since then, the market has seen a raft of new entrants.
Singapore-based Bybit joined the fray in 2018 and has been steadily expanding its offering ever since. One of the most recent features to launch is a Mutual Insurance fund, designed to help users hedge their losses.
The Role of Hedging Instruments
Futures trading can be a high-stakes game. Particularly with futures or perpetuals backed by cryptocurrencies, there’s potential for huge upsides and downsides. Bitcoin and other cryptocurrencies are inherently volatile, meaning traders can profit from price movements even in just a few minutes when trading only on the spot markets.
However, most cryptocurrency futures platforms offer trading at high leverage, further magnifying the potential for gains and losses.
It’s the loss risk that’s seeing an increased appetite for hedging instruments, namely crypto-backed options. Over the last year, open interest in options has more than trebled from $500 million to $1.5 billion.
Using options as a hedging instrument requires a relatively advanced understanding of how the financial markets work. To take an example, let’s assume a trader opens a long position at a BTC price of $10,000. They’re expecting the price to go up, but to hedge their position, they also buy some put options with a strike price of $9,500. If the price of Bitcoin falls to $9,000, they can exercise their options and sell at $9,500, limiting their losses.
The reverse is also true if the trader takes a short position and uses call options to guarantee they can buy at a fixed strike price.
Hedging using options brings additional complexity for traders, not only because they need to understand how various products play together. Keeping track of multiple open positions of different types also creates additional complexity.
Mutual Insurance – A Simpler Way to Hedge
Earlier this year, Bybit launched its Mutual Insurance fund, offering traders an easier and more streamlined way to hedge against losses. Whether a trader is opening a long or a short position, they can opt to have it covered by the fund for up to 48 hours at a time.
The value of the premium is calculated using the Black-Scholes model, the same way that options are priced. It takes into consideration the price at the moment the cover is taken out, and the level of leverage applied to the trade, which indicates liquidation risk. All premiums are paid directly into the Mutual Insurance fund.
If the position enters liquidation, either partially or fully, the insurance fund kicks in and a payout is applied to cover losses. Similarly, a trader can choose to manually settle their insurance, which will also trigger a payout. Otherwise, the payout is calculated at the expiry of the cover period.
Bybit’s Mutual Insurance fund is designed to be self-funding, with premium inflow balancing what’s paid out. Bybit only takes a nominal fee of 0.05% per premium, and the company provided an initial injection to the fund of 200 BTC.
Options vs. Mutual Insurance
The major difference between using options as a hedging instrument and this kind of mutual insurance fund is on the potential upside. Bybit’s Mutual Fund payout is capped at a settlement price equal to the estimated liquidation price of the insured position. There is also a fixed maximum payout per order of $200,000. This contrasts with options contracts, where there is unlimited upside potential.
However, mutual insurance offers many advantages that options don’t. Traders on Bybit can easily take out insurance cover at the time they open their position, with just a few extra mouse clicks, rather than having to open an entirely separate position. It’s uncomplicated and easy to understand.
Furthermore, it’s worth remembering that exchanges trading options are aiming to make a profit from it. Bybit’s Mutual Insurance is transparent and doesn’t have any mechanical edge working against the trader – it simply offers protection against losses.
In offering a straightforward means of protecting against losses, mutual insurance democratizes access to the kind of sophisticated hedging strategies used by more advanced traders. In the high-stakes world of leveraged crypto trading, it’s a useful means for anyone looking to offset their risks.