What Are Crypto Derivatives?
A cryptocurrency derivative is a financial contract representing an underlying asset, which determines its value. With the rise of cryptos as a new digital asset class, the financial industry has launched various products and instruments to meet the needs of a growing number of traders and investors.
Derivatives have long been used in trading stocks, commodities, currencies, and other traditional assets and are now popular in cryptocurrency markets. Traders can use derivatives to gain exposure to an asset’s price fluctuations and speculate on its future performance without owning the asset itself.
The four main types of derivatives are:
Futures and options are the two most commonly traded types in crypto markets. Perpetual futures, for instance, have been developed specifically for cryptocurrency trading.
How Do Crypto Derivatives Work?
Crypto derivatives are available to trade on cryptocurrency exchanges and, increasingly, traditional financial exchanges.
The derivatives used to trade cryptocurrencies work in a similar way to traditional derivatives. The buyer and seller agree to a contract to transfer ownership of the underlying asset at a specified price and time in the future. The derivative itself does not carry any inherent value. For instance, the value of an ETH derivative contract is based on the ether (ETH) price.
Crypto derivatives facilitate market liquidity and offer traders flexibility as well as the potential to make large gains. However, as derivatives often use leverage to borrow most of the position’s value, they expose the trader to the risk of large losses.
Types of Crypto Derivatives Explained
How do the different types of crypto derivatives work?
Futures are contracts that obligate the trader to buy or sell a cryptocurrency at a certain price on a fixed date in the future. This allows traders to make a profit if they correctly discern whether a crypto price will rise or fall.
- A trader can open a long position if they expect the price to increase;
- A trader can open a short position if they expect the price to decline.
Exchanges typically offer weekly, bi-weekly, quarterly, and annual futures contracts. Each contract represents an amount of the specified cryptocurrency. So, the bitcoin (BTC) price of $30,000 would require 10,000 $1 contracts to open a position worth 1 bitcoin.
As with traditional futures, crypto derivatives can be cash-settled, meaning that the trade is settled in cash rather than the transfer of the asset.
For instance, if a trader buys a “31AUG2023 BTC” contract at $30,000, they agree to buy one contract’s worth of bitcoin on 31 August 2023 for $30,000. If the coin trades above $30,000 on that date, the trader makes a profit, but if it trades lower, they lose the money.
As futures contracts represent a position on the crypto price for a specific date in the future, the price of the contract reflects where the crypto is expected to trade on that date, so it does not necessarily closely track the spot – or current – price.
Options are a type of futures contract that gives the trader the right – but not the obligation – to buy or sell a cryptocurrency at a strike price on or before a specified expiry date.
- Call options allow the trader to buy the asset on the specified date;
- Put options allow the trader to sell the asset on the specified date.
There are several fees associated with options contracts:
- The buyer pays a fee known as a premium to buy the contract;
- Brokers charge a flat or percentage-based commission per trade;
- Both the buyer and seller pay contract fees to the exchange;
- The buyer pays interest on borrowed margin funds;
If the price of the crypto on expiry is in the trader’s favor, they can exercise the option to buy or sell. If exercising the option would incur a loss, the trader can choose to let it expire so that they only lose the premium they paid to enter the contract.
Option contracts provide traders with more flexibility than futures, as they can decide whether to execute the contract depending on market fluctuations.
Perpetual contracts or swaps, also known as perps, are a form of futures contract without a fixed expiry date. They use a funding rate mechanism so that the contract price tracks the spot market price for the underlying asset.
The difference between the spot price and the perpetual futures price sets the funding rate – or holding fee.
- If the perpetual contract price is higher than the index price, traders with long positions pay the funding rate.
- If the perp contract price is below the index price, traders with short positions pay the funding rate.
This helps incentivize traders to bring the contract price back toward the spot crypto price. Traders are paid directly rather than via exchanges.
Perpetual contracts are a popular way to trade cryptocurrencies as the markets trade continuously – unlike stocks, for example, which only trade during specific hours and days of the week.
As the name implies, the contracts can be held indefinitely until the holder decides to close the position, so may be suitable for investors as well as short-term traders.
The funding rate mechanism means that prices for perpetual contracts tend to track spot prices more closely than futures.
How Are Crypto Derivatives Used in Trading?
Cryptocurrency derivatives allow traders to speculate on the direction of prices, hedge their portfolios against risk, diversify their holdings, take positions on coins or tokens without owning them, and use leverage to increase their returns. They also help to facilitate market liquidity.
- Speculation: Speculating on financial assets involves capitalizing on market volatility to make a profit from taking a position on expected future price movements.
- Hedging: Traders can use derivatives to manage risk by taking an opposite position to an existing holding to offset potential losses and reduce exposure to market fluctuations. Leverage allows a trader to hedge their portfolio for a fraction of its cost. Derivatives can also predict risk when options are overbought or oversold, allowing traders to adjust their positions.
- Leverage: Leveraged contracts allow traders to multiply potential profits or take a position at a fraction of the cost of a full position. For example, a 10x long contract would result in a profit of 10 times the price gain of the underlying asset. A trader would only need to pay 10% of the full value of a futures contract. However, using leverage also multiplies the risk of heavy losses.
- Diversification: Derivatives help traders to diversify their portfolios across assets and timescales and allow them to develop advanced trading strategies, such as arbitrage and short-selling.
- Liquidity: Liquidity refers to how easily transactions matching buyers and sellers can be completed. In liquid markets, traders can easily open and close positions, whereas illiquid markets have few participants and, therefore, few completed transactions. Introducing derivatives to the cryptocurrency markets has enhanced liquidity, which can lead to reduced price volatility and improved price discovery.
Pros and Cons of Crypto Derivatives
|Ability to profit from falling prices.||High crypto price volatility|
|Maximized gains from leverage||Heavy losses from leveraged positions|
|Market efficiency||Regulatory uncertainty|
|Risk management||Risk of illiquid contracts|
|Diversification||Potential price manipulation|
Crypto derivatives are complex financial instruments that are most suited to experienced traders with the knowledge, skills, and circumstances to use them effectively.
As the cryptocurrency space continues to evolve, the role of derivatives is likely to grow. They offer new ways for traders to engage with digital assets, profit from high-price volatility, and manage portfolio risk.
However, it is important to be aware of concerns that leveraged instruments such as futures and perpetual contracts can increase the prevalence of price manipulation from large market players, and they can multiply losses as well as profits depending on price movements. A spike in the number of highly leveraged positions can also contribute to short-term market volatility.
As cryptocurrencies are a relatively new asset class, regulatory authorities around the world have yet to finalize guidelines, with different countries taking different approaches that could ultimately affect the use of derivatives.
Traders should take a cautious and informed approach to using crypto derivatives, ensuring they understand the risks involved before committing funds.