What are Cryptocurrency Derivatives?

Crypto derivatives have seen enormous growth over the past years. As per Tokeninsight’s Cryptocurrency Derivatives Exchange Industry Report, the trading volume of the crypto derivatives market for Q3 2020 stood at $2.7 trillion. This is based on data taken from 42 exchanges. That implies an increase of 159.4% year-on-year from Q3 2019. 

All these point out that crypto enthusiasts need to be well aware of all the vital details related to crypto derivatives.

Let’s take a closer look.

Cryptocurrency derivative: Basics

Crypto derivatives refer to contracts which derive their value from a primary underlying asset, a cryptocurrency. These derivatives use the same format as traditional derivatives but apply them to cryptocurrency assets.

Cryptocurrency derivatives work similarly to traditional derivatives because a seller and a buyer enter into a contract to sell an underlying asset. These assets are sold at a predetermined price and time. 

Derivatives do not have any inherent value. Instead, they rely on the underlying asset’s value. For instance, an Ethereum derivative depends on and acquires value from Ethereum’s value.

Types of derivatives in cryptocurrency

• Crypto futures

Futures are a type of crypto derivative that institutional investors commonly use. Market sentiment and future price movements are predicted by using data from futures.

These involve an agreement between a seller and a buyer to sell a particular asset in the future. Also, the specific amount and date are agreed on in advance. There may be a variation in contract details, but usually, the terms are similar.

Traders may either lose or gain depending on future price variations. For instance, if Bitcoin’s current price stands at $40,000, you as an investor may either sell or purchase futures contracts in anticipation of a price hike or decline.

Suppose you buy a futures contract worth one Bitcoin ($40,000), and by the time this contract closes, the value shoots up to $60,000. In that case, you will realise a profit of $20,000. However, if there is a plunge in price to $30,000 by the time the contract closes, you will incur $10,000 as a loss.

• Crypto options

Options are another type of derivative contract which enables you as a trader to sell or purchase a particular commodity on a future date at a set price. However, unlike futures, options offer a buyer an opportunity not to purchase a particular asset if they choose.

To purchase a contract, you as a trader need to pay fees. For instance, if an option is worth $800, you will have to bear this cost as a trader to enter, in addition to the actual price of the asset you want to buy.

Irrespective of the trade outcome, you as a trader need to pay the fee of $800. So, it would help if you kept in mind that options are not an entirely risk-free way of trading crypto derivatives.

• Perpetual contracts

A perpetual contract or perpetual swap or a perpetual futures contract is a highly prolific type of cryptocurrency derivative, particularly among day traders. Contracted for difference (CFD) is the equivalent of a perpetual contract in traditional finance.

The major difference between futures and options vs perpetual contracts is that the latter does not have any expiry date. As a trader, you can keep positions for as long as possible, provided that you pay the funding rate or the holding fees. Also, the account must contain a minimum amount, referred to as the margin.

Advantages of crypto derivatives

• Low transaction costs: Derivative contracts are effective risk management tools, lowering market transaction costs. Therefore, transaction costs in derivative trading are cheaper in comparison to other securities like spot trading.
• Higher leverage: As an investor, you can use leverage with derivatives trading to increase profit margins without investing a substantial amount upfront.
• Risk management: Values of derivative contracts are inherently attached to underlying assets. That’s why derivatives are utilised to mitigate risks linked with the fluctuating prices of underlying assets.

Disadvantages of using crypto derivatives

• Higher risk: As the value of underlying assets can witness frequent fluctuations, derivative contracts can be very volatile. That implies that you as a trader are at risk of losses, particularly in leveraged contracts.
• Lack of due diligence: Over-the-counter futures contracts come with counterparty risks, and that is because of a lack of due diligence. As a trader, you cannot effectively run a due diligence check on the other party as over-the-counter transactions always do not follow stringent compliance procedures.
• Regulatory concerns: Derivatives trading is still illegal in several global regions. That means two parties participating in a futures contract should be within the same region where derivatives trading is legal.

Tips for trading crypto derivatives

Different types of cryptocurrency derivatives can be traded officially on both regulated crypto exchanges and traditional exchanges.

There isn’t any formula that ensures you won’t suffer any losses while trading cryptocurrency derivatives. But, some practices you can follow to safeguard your investment and ensure making an informed decision before investing. These include:

• Choose the right derivative depending on the current price fluctuation trend

It would help to determine which derivative is best for you by selecting the right one depending on the current price fluctuation trend. 

• Do not hedge more than the amount that you can bear to lose

You should ensure you don’t hedge more than you want to lose. 

Many seasoned traders borrow assets and sell them to some other individual. While doing so, they hope a future price decrease will enable them to purchase the same assets at a decreased price.

In that way, they can return the borrowed assets to the lender and keep the profits to themselves. But, if there is a price hike, the trader will have to pay the price difference.

• Opt for a trusted trading platform

You should select a reliable trading platform for cryptocurrency derivatives – one which is established, features high trade volumes, verified users and safety measures for fraud detection.

Bottom line

Cryptocurrency derivatives are essential to the crypto economy as their functions stretch far beyond an individual trader’s investment portfolio. Derivatives are a part of any mature financial system, and that’s why they play a vital role in developing cryptocurrency as a recognised asset class.