Profitable traders aren’t just good at gauging which way the market will move: they’re also excellent risk managers, reducing their exposure to loss in the event of things going wrong. Mutual insurance (MI) is a risk management tool that’s available for perpetual contracts on certain derivatives exchanges. It operates like an insurance premium that traders can purchase to hedge against potential loss.
What Is Mutual Insurance?
Whenever you enter a perpetual, options or futures trade, there is the potential for loss in the form of liquidation. Traders who elect to take out MI are effectively insuring themselves against the risk of calling the trade wrong. Normally, when a perpetual contract expires in a loss, you will earn nothing. In crypto parlance, you are rekt. Mutual insurance entitles you to compensation when this occurs.
If you are long on a trade – say BTC-USD – you can take out protection in the event of the asset dropping in price. And if you are short, you can take out protection against BTC going up. Exchanges that provide mutual insurance generally allow traders to choose the percentage of their position they wish to cover; 25% say, or even 100%. For the insurance payoff to occur, certain conditions must be met. If you’re considering taking out insurance, it’s imperative that you read these carefully before you commit.
Mutual Insurance in Action
The theory behind MI is easy enough to grasp. But how does it work in practice? Let’s consider an example. Imagine a trader holds a 10,000 BTC-USD contract at $9,000 and chooses to purchase 50% short protection. The insurance will be 5,000, to cover 50% of their contracts. To secure 100% of their contract, the trader would have to take out insurance on an additional 5,000 contracts.
Upon taking out insurance, the trader will be quoted an index price for the asset at the time of opening the cover, and an expected liquidation price. For a trader who is short bitcoin at $9,000, the liquidation price may be $10,000. If the price of BTC-USD increases, the short protection will cover the loss up to the price increase to $10,000.
Mutual insurance is taken out for a specific period of time. This may be as short as two hours or as long as 48 hours or more. If the trader’s position is liquidated, any insurance settlement that is due will pay out automatically. If their position is only partially liquidated, the insurance will pay out proportionally.
With mutual insurance, the maximum loss you can incur is the cost paid for the insurance premium.
How Bybit Approaches Mutual Insurance
One of the most popular derivatives exchanges offering mutual insurance is Bybit. Introduced in May, the service offers short-term protection for users trading BTC-USD options. It allows them to obtain short-term cover for their longs or shorts, covering them in the event of a sudden market move within the space of 2-48 hours that would otherwise liquidate their portfolio.
The fund was started with 200 BTC supplied by Bybit, and all premiums purchased by traders are added to the fund. The provision has been dubbed as “social insurance” and has safeguards in place to protect traders while preventing the fund from being drained. The minimum insurance amount is $500 and the max is $200,000 per order.
Deribit provides a comparative product, through offering a two-way market for options, protecting traders against longer-term options that are due to expire soon, while Binance offers warrants that operate as a basic options product. The main difference between the insurance products offered by these exchanges is that Bybit’s mutual insurance pool is more transparent, with the balance of the pool clearly displayed at all times. Binance’s warrants, which enable the underwriter to set the pricing, are susceptible to abuse through the exchange levying punitive fees. These have caught out many an inexperienced trader and provoked the ire of more seasoned heads.
Should You Buy Mutual Insurance?
If you are seeking short-term protection on an options position you have open, MI is worthy of consideration. It can provide you with the confidence to keep your position open for longer, in the knowledge that you won’t be rekt even if the market moves against you. For nervy traders, knowing that MI will bail them out in a worst case scenario, means they can sleep easy and avoid closing out an ultimately profitable position too soon. For instance, mutual insurance on a long BTC-USD option means you are protected against downside risk, while retaining unlimited upside. If your trade goes the way you were expecting, you’ll be in the money, and the peace of mind afforded by the mutual insurance premium will have been well worth it.
The flip side of this, of course, is that if you’re frequently purchasing mutual insurance but are rarely triggering a payout, you’re wasting money that could be better spent on increasing your position size. Mutual insurance is a valuable tool that can prevent traders from getting liquidated by the sort of freak moves that are part and parcel of trading bitcoin. Use it wisely, use it judiciously, and it’ll save your ass.