How Can a Trader Attempt to Minimize Basis Risk When Hedging?
A trader can minimize basis risk primarily by using a futures contract that is highly correlated with the asset being hedged and has an expiration date close to when the hedge is needed. Furthermore, choosing a contract that is based on the same underlying asset or index as the spot position is crucial.
Traders also often monitor the historical basis relationship and may adjust the hedge ratio if they anticipate an unusual divergence between the spot and futures prices.
Glossar
Hedge Ratio
Calculation ⎊ The Hedge Ratio quantifies the necessary size of a derivative position required to offset the price risk inherent in an underlying asset or portfolio, representing the change in the derivative's price relative to the change in the underlying.
Historical Basis Relationship
Basis ⎊ The historical basis relationship, within cryptocurrency derivatives, options trading, and financial derivatives, describes the dynamic difference between the spot price of an underlying asset and the futures or forward price.
Basis Risk
Exposure ⎊ The core of basis risk within cryptocurrency derivatives, particularly options, stems from the imperfect correlation between the price movements of the underlying asset and its derivative contract.
Expiration Date
Deadline ⎊ The Expiration Date marks the definitive deadline for the option contract, after which the right to exercise or the obligation to perform ceases.
Underlying Asset
Futures Pricing incorporates the cost of carry, which in crypto markets includes funding rates derived from perpetual swap markets and the time value associated with holding the spot asset.
Spot Position
Position ⎊ The outright ownership of the underlying cryptocurrency asset, held directly on the blockchain or through a centralized custodian, which serves as the base asset for derivatives hedging.