A derivative is a contract between a buyer and a seller to speculate the future price movements of a financial asset without buying the asset itself, i.e., both parties bet on the future of the asset with the hope of making a profit without holding the said asset in their portfolio.
Derivative trading is not peculiar to cryptocurrency markets; it has long existed in traditional financial markets like stocks, bonds, commodities, etc.
What are crypto derivatives?
Crypto derivatives are similar to traditional derivatives; it involves a contract between a buyer and a seller to speculate on the future of a particular crypto asset without buying the asset; as a result, derivatives don’t have inherent value – they rely on the value of the asset.
To make this clearer, let’s use an example. If you buy 1 BTC in your wallet at $20,000 per unit, and the price rises to $25,000, you have made a $5,000 profit by holding the BTC in your wallet; conversely, if the value drops to $15,000, you’d have made a loss; however, regardless of the outcome, you still have 1 BTC in your wallet.
On the other hand, if Bitcoin was $20,000, and you enter a derivative contract with a prediction that Bitcoin will rise to $25,000, you’d make a profit if the outcome is correct; however, if your prediction is wrong, you’d lose money and have no crypto asset in your wallet.
Since derivatives don’t require buying the asset in your wallet, they also offer ways for traders to mitigate their investment risks by hedging against their investments via derivatives. For example, after adding BTC to your portfolio via the spot market, you could bet against BTC in the derivatives market, predicting that the price will come down; simply put, you are only trying to minimize your losses in case your spot trading investment goes south.
Types of Crypto Derivatives
There are three major types of crypto derivatives: futures, options, and perpetual contracts. All three methods provide unique approaches to taking a position in the market.
Crypto futures involve a contract between two parties to buy and sell a crypto asset in the future (of course, without actually holding the asset). The specific date for settling the contract is predetermined, so, at the end of the contract period, the asset’s current price will determine who has made a profit or loss.
For example, if two traders, trader A and trader B, are automatically matched by a derivative trading platform to enter a weekly futures contract to trade Bitcoin (BTC) derivatives, and each contract is worth $1 of BTC, they can enter any number of contracts to open a trading position.
Usually, both traders are paired on opposite sides of the divide; hence, if Trader A goes long (predicts that the price of Bitcoin will increase within a week), and Trader B goes short (predicts that the price of Bitcoin will fall in the same period). Then, at the end of the contract period, Bitcoin would have moved, and one of the traders must pay the other.
If Bitcoin rises, trader A will pay trader B; on the other hand, if Bitcoin falls, trader B will pay trader A.
Crypto “options” is a derivative contract that allows a trader to buy or sell a crypto asset at a set price on a future date (similar to futures). However, crypto options may not be settled at the contract expiry date, giving the trader the “option” to exercise the contract or not.
Unlike futures, you don’t enter long and short positions; instead, you have the option to “call and put.” For example, if you enter a Bitcoin contract option to buy Bitcoin at $18,000 in a week; on the settlement date, if Bitcoin is $20,000, then you have to buy it at a higher price than you bargained for; alternatively, you may choose the option of not exercising your contract and letting it expire, but you would lose the premium you paid to get into the contract.
What if my price target is reached before the contract’s expiry?
There are two types of options; American and European options. The former can be settled before the contract’s expiry date, while the latter can only be settled on the agreed date. Hence, if trading American options, you would get the extra option of exercising your contract before the agreed date.
However, regardless of the trade outcome, crypto options require the trader to pay a premium. Hence, traders must evaluate their risks before opening an “options” position.
Perpetual contracts are the most common type of derivatives contracts, especially among day traders. Unlike futures and options, perpetual contracts do not expire; traders can keep positions indefinitely, as long as they have enough funds to avoid liquidation.
Perpetual contracts are pretty similar to futures; however, since they don’t have a specific settlement date, they use a funding mechanism, where long and short traders exchange a funding cost to reflect the spread between the actual price of the token in comparison with the perpetual contract. Simply put, when the funding rate is positive, all long traders must pay funding costs, and when the funding rate is negative, short traders must pay funding costs. This helps balance both sides of the divide, helping to have similar levels of short and long traders; in other words, it becomes practically impossible for everyone trading to go in similar positions.
For example, if you open a long position while trading perpetual contracts, you can hold your position for as long as you want; the moment you choose to close your position, the derivative trading platform will calculate the difference between your entry and close, and then pay you the difference (this payment isn’t generated from thin air, but from another trader who opened a short position and lost).
Leverage in Perpetual Contracts
Perpetual contracts allow traders to hold leveraged positions; that is, they can trade bigger positions than their margin price. So, for example, if you have a $100 margin, you can open a $5,000 trading position with a 50X leverage, giving you the chance to exponentially multiply your profits (or losses).
Advantages of Derivative Trading
- It allows crypto traders to hedge against their spot positions, thereby mitigating possible losses.
- It allows traders to operate with higher margins, boosting their chances of huge profits.
- Derivative trading charges meager fees
- Derivative trading keeps the cryptocurrency market active by injecting high liquidity into the market, improving market momentum.
- The biggest drawback of derivative trading is the risk factor of traders losing a lot of money upon closing the contract. In spot markets, if the asset purchased plummets in price, investors can hold on, waiting for it to rise again. However, with derivatives, once the contract is settled, you can either go home with a profit or a loss; no asset is in your wallet.
- Also, traders could overleverage, losing money and getting badly burnt. Hence, leverage is a tool for making more money and, at the same time, a tool for quickly getting bankrupt.
With greater rewards come greater risks; therefore, you should always tread cautiously when trading derivatives. Hence, it is crucial to have a trading strategy and make informed decisions before going long or short.
Ensure not to overleverage your positions, as the crypto market is volatile, and you can get badly burnt.