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Hedge ratio

The hedge ratio is the ratio between the size of a futures position hedge and the spot market value of the hedged position itself.

Hedge_ratio = futures_position_vlaue / spot_market_value

For example, if you have $100,000 exposure to the price of bitcoin, you can hedge this risk by opening a short futures position with a notional value of $100,000. In this way, every move down in the price of bitcoin is offset by the gain in the futures market and vice versa. If the historical price data indicates a perfect correlation between these two instruments, the hedge ratio of 1.0 is sensible (i.e. futures position is of the same value as the spot market position).

However, if the past price data indicates that the futures market used for hedging is, let’s say, twice as volatile as the underlying spot market (for every $1.00 move in the spot price, the corresponding futures market moves $2.00 in both ways), the hedge ratio of 0.5 is suitable. In other words, the size of a futures position should be twice less (hedge ratio = $50,000 / $100,000 = 0.5).

Hedge ratio from example above
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