What is hedging? Options, puts, calls, and why lenders use them

What is hedging? Options, puts, calls, and why lenders use them

The concept, in plain language

Hedging means taking a second position that offsets losses on a first one. You own something that might fall in value. You buy protection that pays out when it does, and you pay for that protection whether the fall happens or not.

Take a corn farmer who plants in April and harvests in October. Prices might fall in between, so in April the farmer sells corn futures at today's price. If corn has lost value by October, the futures contract has gained roughly the same amount, and the farmer's income holds steady.

That's hedging in one line: own a risk, buy an offset, pay for the offset.

The main instruments

Two instruments dominate hedging: options and futures. Both are derivatives, contracts whose value comes from an underlying asset. Options give the holder a right but not an obligation. Futures lock in a price now for settlement later, and both sides are bound.

A put option is the most direct downside protection. A put on Bitcoin with a $50,000 strike gives the holder the right to sell at $50,000 whatever the market price. If Bitcoin falls to $35,000, the put is worth $15,000. If Bitcoin holds or rises, it expires worthless.

The cost is the premium, paid up front. Premiums depend on the strike, the time to expiry, the current price, interest rates and, above all, volatility. Higher volatility makes a payout more likely, so protection costs more.

A call option is the mirror image: the right to buy at a fixed price. Hedgers use calls to protect a short position against a rise, or sell them to earn premium.

Why lenders use them

When a lender has lent against crypto collateral and the price falls, the loan-to-value ratio rises toward the liquidation threshold and the borrower's headroom shrinks. A put with a strike below the current price gains value as the collateral loses it, offsetting part of the fall.

Cost is the catch. Protection is most expensive exactly when it's most needed, because premiums rise with volatility. Over a long facility, paying for protection every quarter adds up.

That's why lenders often combine structures:

• A put spread buys protection at one strike and sells it at a lower one, cutting the cost but leaving the deepest falls uncovered.
• A collar sells a call to pay for a put, giving up upside in exchange for cheaper downside cover.
• A funded hedge sets aside part of the income from the position to pay for protection over time.

What hedging can and can't do

A hedge reduces the impact of a price fall; it doesn't make risk disappear. Coverage can be partial, hedges have to be rolled before they expire, and the hedge may not track the collateral exactly. Conservative loan-to-value limits and liquidation buffers still matter alongside it.

When looking at any crypto-backed product, ask whether positions are hedged, with what structure, what it costs, and what's left uncovered.

For deeper reading, see Hedge strategies: collars, put spreads, funded hedges, covered calls and How institutional lenders price option hedges: SVI, SABR, Vanna-Volga, PCHIP.