Derivatives In Crypto | Types, Benefits & Risks
Despite the revolutionary promise, cryptocurrencies have integrated into the existing trading practices as another tradable asset. During the early 2010s, cryptocurrency trading began adopting traditional market strategies, technical indicators, and patterns.
Bitcoin futures trading first emerged in 2011, but this event did not immediately spur a trend. It was during the second half of the 2010s, notably in 2019, that interest in crypto derivatives surged, with these instruments becoming available on numerous large platforms.
This article discusses the definition of derivatives, explores the specifics of crypto derivatives, and highlights their advantages and disadvantages, among other topics.
- What Are Derivatives?
- Derivatives in Crypto Trading
- Types of Crypto Derivatives
- Benefits and Risks
- Conclusion
What Are Derivatives?
Derivatives are financial contracts whose value is determined by an underlying asset, a group of assets, or a benchmark. They can be traded either on exchanges or over-the-counter (OTC) desks.
The price of derivatives fluctuates based on the value of the underlying assets. Traders commonly use derivatives to hedge against risk. They also offer access to certain markets that permit the use of significant leverage, which dramatically amplifies potential trading rewards as well as risks.
The introduction of derivatives plays a crucial role in the development of a robust market as they help manage risks, stimulate liquidity, and facilitate price discovery. These combined effects elevate emerging markets to new heights, and the cryptocurrency market is no exception.
All these aspects, influenced by derivatives, interact with each other. High liquidity helps to moderate the notorious volatility of cryptocurrencies. When a market has a low liquidity, the bid-ask spread can become sizable, rendering trading excessively risky. Furthermore, transaction costs increase, discouraging potential traders and investors. Institutional investors and traders, unable to risk the substantial amounts they usually deal with, may also shy away from low-liquidity markets. Decreased risk enables traders to make more informed trading decisions.
Markets with high liquidity tend to attract new investors, traders, and other participants, making subsequent market development more transparent. This leads to fairer asset distribution and reduces opportunities for fraud and manipulation.
The most common types of derivatives are futures contracts, options, forwards, and swaps. The most prevalent underlying assets for derivatives include stocks, bonds, currencies, interest rates, commodities, and market indexes. This article, however, focuses on crypto derivatives.
Derivatives in Crypto Trading
As the cryptocurrency market skyrocketed, the demand for crypto derivatives tagged along, showing us the unstoppable power of crypto. By the 2020s, many large exchanges had introduced the trading of crypto futures and other derivatives.
Crypto derivatives, like all derivatives, derive their value from underlying assets — in this case, a cryptocurrency or a group of cryptocurrencies. These derivatives act as contracts to buy or sell an underlying cryptocurrency (or a set of cryptocurrencies) at a specific future date. Such contracts can involve two or more parties.
Types of Crypto Derivatives
In crypto, the most usual types of derivatives are regular and perpetual futures and options.
Crypto Futures: A crypto futures contract commits the buyer to purchase or sell an underlying crypto asset (or a group of assets) at a specified future date and price.
For example, suppose John purchases a "15NOV2023 BTC" futures contract at $25,000. This means John agrees to buy 10 BTC, as specified in the contract, at $25,000 per 1 BTC on November 15, 2023. If the market price for BTC is above $25,000 on that day, John effectively saves money. If the price is $26,000 per BTC, John saves $10,000 on his purchase of 10 BTC. Conversely, if the price falls below $25,000, John incurs a loss.
At the time of entering into the futures contract, the agreed-upon price of the underlying asset may be significantly different from its current spot price. The contract price reflects the parties' expectations.
Crypto Perpetual Futures: Perpetual futures contracts differ from standard futures in that they do not have an expiry date. As a result, these contracts can be traded whenever the contract price approximates the current market price.
Crypto Options: Options share similarities with futures, but while futures contracts require buyers to purchase or sell crypto at a certain time and price, options give buyers the right—but not the obligation—to do so. The buyer of an option is referred to as the "holder," and the seller is called the "writer." "Call options" give the holder the right to buy an underlying asset under agreed-upon conditions, while "put options" grant the right to sell the asset.
For instance, John buys a "15NOV2023 BTC" options contract, granting him the right to buy 10 BTC at $25,000 on or before November 15, 2023. However, if the price of BTC is $15,000 on that date, he can choose not to buy the 10 BTC, thereby avoiding a loss of $100,000. Instead, he pays a small fee to the contract seller. In this way, crypto options offer a flexible risk management strategy.
Benefits and Risks
Derivatives offer both benefits and risks to traders. They necessitate specific strategies that diverge from those used in trading regular assets. By understanding the nuances of derivative trading, they can substantially mitigate risks.
One of the main advantages of derivatives is that they are generally less expensive than their underlying assets. Moreover, the conditions under which the underlying asset can or must be sold or purchased are flexible, particularly in the case of perpetuals and options. This flexibility equips derivative holders with powerful risk management tools in an unstable market.
In addition to their relatively low cost and flexible conditions, crypto derivatives are often traded with considerable leverage—much greater than that available for cryptocurrency trading. This enables traders to amplify potential profits while minimizing outlay. The availability of derivatives also allows for portfolio diversification, further reducing risks associated with price fluctuations.
However, despite their effectiveness in managing risk, derivatives trading introduces its own risks. The cryptocurrency market is known for its volatility, and an abrupt shift in market trends can result in substantial losses for crypto derivatives traders. The use of leverage can intensify these losses.
Legal issues also present challenges: not all jurisdictions permit trading in crypto derivatives. It's important to ensure that local laws do not prohibit derivatives trading before you begin.
Furthermore, caution is needed when trading derivatives over-the-counter due to counterparty risks. Regulated exchanges can impact profitability through due diligence procedures. Finally, derivatives are difficult to value. Their worth depends on the future price of the underlying asset, which can vary dramatically by the set date. Also, derivative contract prices are not fixed, contributing to the complexity of valuing them.
Please note that this article does not offer investment advice. If you're considering trading crypto derivatives, be sure to conduct thorough research into the assets you plan to trade and ensure that your chosen platform is reliable.
Conclusion
Trading in derivatives requires a deep understanding of crypto market trends and price formation mechanisms. Although derivatives can help manage risks, the possibility of magnifying trading returns through high leverage, which can be a double-edged sword, especially for inexperienced traders. In general, the widespread introduction and adoption of crypto derivatives indicate the maturation of the cryptocurrency market, benefiting all market participants overall.