Crypto Derivatives: Everything You Need to Know

Cryptocurrencies have gained massive attention since 2017, a year regarded as one that heralded the influx of initial coin offerings (ICOs). Since that period, investors- both institutional and retail- have adopted different means to profit from them. Though cryptocurrencies did not catch the fancy of institutional investors until perhaps 2020, the current year has witnessed a series of significant investments from them into crypto assets as they begin to make headway into the mainstream sector.

While cryptocurrencies like Bitcoin and Ethereum have become good investment choices for crypto enthusiasts around the globe, they also present greater risks that investors are normally wary of. In other words, as much as they are able to provide profitable returns, they are also capable of incurring significant losses for investors and traders. As such, expert traders and experienced investors like Dan Hollings resort to strategies to limit their losses on these assets to the barest minimum, because losses are not entirely avoidable.

Drawing from the above, they either adopt tested and proven trading and investment strategies or protect themselves from the inherent volatility via what is known as a crypto derivative.

What are Crypto Derivatives?

They are described as secondary contracts or financial instruments which derive (as indicated by the term ‘derivative’) their value from primary underlying assets, usually cryptocurrencies. That is, their relevance is underlined by the value of a primary asset. A derivative or derivatives is often regarded as a financial contract, initiated between two parties or more for the purpose of speculating on the future price of an underlying asset. In derivatives, there must be an underlying asset as this is what gives relevance to the initiated contract.

Although derivatives date back to medieval times when merchants speculated on the prices of commodities, crypto derivatives are a recent innovation. In light of the above definition, crypto derivatives derive value from a crypto asset, for example, Bitcoin. This means two parties can speculate on the price of Bitcoin. While one party goes ‘short’ on BTC price, which is currently at $47k, the other can go ‘long.’ Essentially, this indicates that one party is of the opinion that the price of the flagship cryptocurrency will fall, but the latter thinks BTC will continue its uptrend till it gets to a specific price.

Since it is very easy for either party to renege on the initial agreement, a crypto exchange acts as an escrow and ensures that both parties keep to their side of the bargain. A crypto exchange like Binance matches those who have gone short on Bitcoin prices with those who went long. If BTC moves up, the ‘short’ traders get liquidated and the ‘long’ traders make profits on their investments. In contrast, if BTC goes short as anticipated, the ‘short’ traders are in profit.

When trading crypto derivatives, traders never really own the primary underlying crypto asset; they only speculate on their outcomes. This is done to protect themselves from likely losses that may result from owning the assets due to volatility. In summary, they only trade contracts that follow the price of the crypto asset — in this case, Bitcoin. This is what differentiates the spots market or trading from derivatives trading. So even when the price of Bitcoin goes down, traders and investors can often capitalize on that to make quick gains, unlike spots trading. Still, derivatives trading comes with its own risks.

There are forms of crypto derivatives. A trader can decide to adopt any of them as a trading strategy. The most recognized forms include futures, perpetual and options contracts. Let’s take a dive into each of them.

●   Futures Derivatives

Using our Bitcoin example in Crypto Derivatives, Bitcoin Futures exist as an agreement between two parties to buy and sell Bitcoin at a particular price and on an agreed date in the future. Here, and with all other derivatives, both parties are not required to hold Bitcoin or any other preferred crypto asset. However, the distinctive feature of futures derivatives or trading is the specific date at which the agreement will be settled. More often than not, traders use stablecoin USDT to trade futures because of its less volatile nature.

Futures traders would normally have to wait for the settlement date, at which point they get to know if they are in loss or in profit. As already indicated, they can either long or short Bitcoin with USDT as the secondary asset. If in profit, those who lost because Bitcoin went in the opposite direction would have to pay the other parties. The duration on futures derivatives could be daily, weekly, bi-weekly or even monthly, depending on the options available.

●   Perpetual Derivatives

Perpetual contracts really stand out from Futures because they do not carry settlement dates. Owing to this, a trader is allowed to open positions for as long as he wants. Still, he has to fulfill some conditions, one of which is having a margin. A margin represents the minimum amount of funds a trader is obliged to open a perpetual position with. Notwithstanding, he can expand his position through what is known as leverage. For example, a trader can open a position of $10,000 just with a $100 margin by using a leverage of 100x. This feature is only applicable to perpetual contracts and gives room for traders to make more profits. When traders capitalize on the ‘leverage’ feature, they also expose themselves to higher risks.

Another unique feature in this crypto derivatives type is what is referred to as the ‘funding rate.’ The funding rate is used to settle either party who is in profit and also helps to bring the price of the asset back to its market price since it is possible for an asset to wander far off from its market price because there is no time limit.

●   Options Derivatives

Contracts under options come with a time limit, but without an obligation to fulfill them. Also, in options, the common terms in futures- Long and Short- are replaced with ‘Call’ and ‘Put.’ On its part, the ‘call’ option instills the right to buy Bitcoin in the trader. On the other hand, the ‘sell’ option allows the trader to sell Bitcoin as soon as the contract elapses. But these rights are, nonetheless, unenforceable.

For instance, if a trader opts for a call option that will enable him to buy Bitcoin at $47k on the agreed date, he retains the choice to decide whether he wants to purchase Bitcoin at that price or not. Most likely, the trader will fulfill the call option if BTC has moved to $48k, giving him the opportunity to buy Bitcoin at $47k and sell at $48k to make a profit of $1,000. The $47k price is otherwise known as the strike price. Where the price of Bitcoin drops below the strike price, the trader can let the contract elapse without abiding by the original agreement.

In the event that this happens, he loses what is known as a premium, which represents compensation for the opposing party. Every option usually has a premium attached to it, which is determined by the conditions of the market at the time the contract is initiated. Thus, the derivative of the option is not without risks.