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How To Hedge Against Risk When Investing in Bitcoins

Updated on February 8, 2014
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Understanding the Risks of Investing in Bitcoin

Bitcoin is an exciting new digital currency which is gaining in popularity. It offers low cost international transactions, and is a cross-border currency unit which may people believe could have dramatic advantages for international business - particularly over the internet. For many people it also offers an appealing alternative to the traditional banking system, and the creation of money by central banks and their inflation boosting printing presses.

From an investment perspective, its price has soared over recent years - meaning that owning Bitcoins would have beaten any other investment by many times over. If Bitcoin manages to move out of the fringe geek culture which has driven it this far, to gain widespread adoption by the general public, there is plenty of potential for the price to keep going up dramatically . For this reason many people see it as an opportunity to invest money by simply buying and holding Bitcoins, and potentially make very large returns. If you believe in the potential of Bitcoin to make the world a better place and want to see it succeed anyway, then an investment like this can combine making money with that warm feeling of 'doing the right thing' - a rare combination indeed.

But this is not an investment for the faint-hearted. Investing in Bitcoins comes with a substantial risk that the value of the coins you own could plummet instead of soaring. Although the high levels of volatility seen at the end of 2013 seem to have died down, leaving the value of Bitcoins in a reasonably narrow price range so far this year, there is no telling what the future could bring for such a new and revolutionary technology.

Even if you are buying Bitcoins purely to use rather than as an investment, the risk of losing money is not something you can simply discount.

Fortunately there are things that you can do to hedge against the currency risk of owning Bitcoins.

Buy Alternative Digital Currencies

Bitcoin has provided a powerful 'proof of concept' for digital currency. But it wasn't the first (that honour goes to 'Ven', the currency used by the Hub Culture community) and it isn't the last. There are many other digital currencies out there, which have collectively been dubbed as 'alt coins' to express the fact that they are viewed as alternatives to Bitcoin.

Many of these alt coins are simply jumping onto a fast moving bandwagon, and actually have little that is original or unique to offer. But some have created genuine improvements over Bitcoin in terms of speed, security, energy efficiency, transaction cost and breadth of functionality. If you believe in digital currency but currently only own Bitcoins then you may want to consider diversification.

If Bitcoin prices continue to rise then there is a good chance that the prices of alt coins will rise too (although perhaps by less) as Bitcoin acts as a trailblazer to create a new market which they can all capitalize on. So far the average prices of many alt coins have been fairly strongly tied to the price of Bitcoins. But if Bitcoin suffers from a price crash as a result of a legal or security problem that one of these alt coins solves, or if the new features they offer start to catch on and draw a greater market share, they could see meteoric price rises.

You can take a look at one of my other hubs to learn more about how to choose the best alt coin to buy and to see my own top recommendations.

A Small Selection of the Available Alt Coins:

Source

Buy Apple Shares

Believe it or not one of the biggest long term threats to the innovative new technology that is Bitcoin may not come from regulators or hackers, but from one of the biggest companies in the world - and one that has always had a reputation for being the 'great innovator'.

I'm talking about Apple, of course. Although many people think of Apple as an innovative company, they have never really invented new products. The entire modus operandi of the company is, and always has been, to look for new technologies invented by others, and produce more polished versions to corner the market just when that technology is on the verge of mass adoption. They did it with MP3 players, tablet computers and smartphones, and they are planning to do it with digital currency.

Apple users may have noticed that all Bitcoin wallet apps have been banned from the Apple App Store. What you may not realize is that the reason for this is because in 2012 the company filed patents related to digital payments which appear to show the companies plans for its own 'iMoney' product to compete with Bitcoin and the alt coins. Make no mistake - Apple wants to be the ones who take digital currency to the masses, relegating Bitcoin to a footnote in history.

As much as I believe in Bitcoin and its ability to withstand this kind of competition from the corporate world due to the network effect of its distributed nature, nobody can discount the threat that Apple poses to the chances of Bitcoin attaining widespread adoption amongst the general public. So although it pains me to say it, due to my dislike for what Apple is trying to do - from a purely financial perspective it may be wise to hedge against this threat by buying Apple shares. Apple is probably going to be a fairly safe investment whatever happens with digital currency, and if they succeed with their plans for 'iMoney' then they will certainly make a lot of profit for their shareholders.


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Profit from Arbitrage

Although some people today are buying an holding Bitcoins as an investment, you can also use your coins to make other kinds of investment.

If you want to stay within the Bitcoin ecosystem then one way to do this is through arbitrage. Arbitrage is when a trader takes advantage of price difference between two exchanges - buying at one price and (almost) instantly selling at a higher price in a different marketplace. There is a huge opportunity for this at the moment within the digital currency world, and you can actually do it yourself by simply opening accounts at as many exchanges as you can and sitting in front of your computer screen looking for opportunities.

For people who would rather have somebody do this for them - somebody with automatic trading bots that can make the trades much faster than a person and can spot opportunities without a person having to be permanently staring at a computer screen, there are trading funds available which you can invest in using either dollars or Bitcoins. Because these funds can make money regardless of whether the price is rises or falling, just as long as there is a divergence between different exchanges, this can provide a way to profit from digital coins without the risk of losing money from a falling price.

Please be aware, however, that this is not entirely without risk. During times of very high volatility the price can change between when the trader buys and when they attempt to sell - even if the whole process is done in seconds or less by a trading bot. This can lead to losses.

Hedging Strategy Comparison

Buying Alt Coins
Arbitrage
Apple Shares
Short Selling
High Risk
Medium Risk
Low Risk
Minimizes Risk
Very High Potential Returns
High Potential Returns
Medium Potential Returns
Low Potential Returns
Supporting Digital Currency
Using Digital Currency
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Take Short Positions During Times of High Risk

There are certain times when the risk of a price drop is heightened. Perhaps an announcement is expected from an influential regulator which could have a negative impact, for example. You probably won't want to have to sell all of your currency and then buy it back afterwards, but the risk of a big drop may make you feel uncomfortable.

One way to hedge against this kind of risk is to take out temporary 'short sell' positions. Several trading platforms offer the ability to short sell Bitcoin with leverage - meaning that you profit if the price goes down. You can set a stop loss meaning that if the price goes up you automatically close your position when it hits a certain value specified when you open the trade.

During these times of high risk the chances of a big drop in price may be much greater than the chances of a big jump, making short selling a good hedge. You simple open a trade with a tight stop loss just above the current price. If there is no bad news then the price may go up a little bit or stay the same, and you would therefore lose a little bit of money on your trade. But if the price plummets then the leverage means you can make enough to cover all of your losses on your Bitcoin holdings even though you may have only spent 5-10% to open the trade.

My Favourite platform is Plus500, which offers practice accounts, and generous bonus funds when you make your first deposit.

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    • F S Miller profile image

      F S Miller 2 years ago

      I'm sure this was an excellent article, but, after I saw the second picture, I could no longer focus. Thanks for making my day.

    • electronician profile image
      Author

      Dean Walsh 2 years ago from Birmingham, England

      There are more and more apps and services aimed at a mainstream non-geeky audience, but it may be that what really pushes the average 'main in the street' to bitcoin will be another economic crisis which shows people just how bad the banks really are and how dangerous it is trusting them with our entire economy as we do now.

    • moviesreviews profile image

      Billy Taylor 2 years ago from NY

      Could not agree with you more when you stated that once it moves out of the geeky stage and into more mainstream folks, this thing could really take off.

    • FlourishAnyway profile image

      FlourishAnyway 3 years ago from USA

      I did not know about Apple and their iMoney endeavors. Very interesting!