Crypto Derivatives: What Are They and How Do They Work?

When people think of cryptocurrency trading, they usually associate it with traditional spot markets that involve buying, selling, and exchanging different digital assets.

But there is more to it than that. For example, you can take advantage of some financial instruments to profit from the movements of cryptocurrencies, but without owning the underlying asset.

Coins such as Bitcoin are very volatile. If you are a trader, you can take advantage of that volatility and profit from it. However, this isn’t an ideal situation for everyone. Suppose you own a shop that accepts crypto, provide services in exchange for cryptocurrencies, or you are a miner. In that case, you would want the price to stay as stable as possible and be in profit no matter what.

Luckily, you can protect yourself from unfavorable market movements by using crypto derivatives. Let’s take a look at what they are, how they work, and what advantages they can offer you.

What Are Crypto Derivatives?

Crypto Derivatives: What Are They and How Do They Work?

Crypto derivatives are financial instruments whose value is derived from a certain underlying cryptocurrency. For example, a Bitcoin derivative would obviously get its value from the price of Bitcoin. Derivatives aren’t something exclusive for the cryptocurrency market. You can find them in traditional financial markets where their value is derived from stocks, commodities, bonds, and even fiat currencies.

This type of trading tool is gaining popularity every day because it allows you to profit from market movements, whether the prices are falling or rising. What’s even more appealing is that you don’t have to buy and hold the underlying crypto asset to take advantage of crypto derivatives.

So, what are they? A crypto derivative is an agreement or contract between two parties: a buyer and a seller. They agree to buy or sell a cryptocurrency like Bitcoin at a specific time in the future and for a specified price. As such, the two parties are predicting and speculating what a coin will be worth one day. Whoever wins gets paid the price difference by the opposing side. Depending on the type of binding contract, traders will either have an obligation or just an option to buy or sell.

Is There a Difference Between Crypto Derivatives and Traditional Spot Markets?

Yes, there is. With derivative products, you don’t have to worry about which wallets to store your coins in and how to keep your seed and private keys safe. Furthermore, as stated previously, you never have to buy the asset you are speculating on.

Buying and selling on spot markets is the exact opposite. You are purchasing a particular coin. The way to profit from spot trades is to buy at a cheaper rate and sell when the price goes up. You make money when the prices rise, and you lose money if the value depreciates.

If you purchased Bitcoin at $20.000 and the price went up to $30.000 at the time you exchanged it to fiat, you would have made a nice $10.000 profit. But, contrary to that, if the price dropped to $10.000, your trade would have been unprofitable.

That wouldn’t have been the case with crypto derivatives if you predicted a price drop and a bear market. This financial tool allows you to go short on bitcoin and profit from a downtrend. Alternatively, you can go long and make more money if the future price turns out to be higher.

Types Of Crypto Derivatives

There are 3 primary types of crypto derivatives:

  • Futures
  • Options
  • Perpetual Contracts

Futures

Crypto Futures obligate two counterparties to buy and sell a crypto asset at a fixed rate at an agreed-upon future time. This type of contract is obligatory and will be executed once it expires. Futures contracts aren’t settled in crypto. Instead, they are usually paid out in USD unless two parties agree to something else.

Let’s explain this in simple terms. Imagine that the current BTC value is $20.000. John speculates that in two weeks from now, Bitcoin will rise. So, he opens a long position on a futures contract. On the other hand, Sara believes that Bitcoin’s value will go down in the weeks to come. So, she decides to short BTC and accept John’s counteroffer.

After two weeks, they have to settle their accounts. So if Bitcoin’s underlying value went up to $25.000, Sara would have to pay John the $5.000 price difference. On the other hand, if the future valuation went down to $15.000, John would have to pay Sara a $5.000 fee.

Options

Crypto options are similar to futures but with one distinguishable element. They don’t include an obligatory clause to sell or buy. They only provide the buyer/seller with an option and a possibility to do so. Traders have a right to fulfill the contract, but not an obligation.

With options, you don’t go long or short like with futures. Instead, you use ‘call’ or ‘put’. Let’s consider the same example with John and Sara from above. They closed a bi-weekly options contract at $20.000. After its expiration, they now have a choice of what to do.

If the BTC price rose to $25.000, it would make sense for John to use the ‘call’ option. After all, he would be buying BTC for only $20.000, which would ensure a $5.000 profit if he immediately sold the asset at $25.000. Sara would take advantage of the ‘put’ option and decide against purchasing Bitcoin in the exact same scenario. If she ‘called’, she would lose $5.000 in that trade.

If you think that option contracts are risk-free because they don’t have to be settled, you are wrong. These financial instruments entail a premium or a fee that has to be paid to buy the contract. For example, that fee can be $1.000, and it has to be paid by both parties. So instead of losing $5.000 in the trade with John, Sarah would let the contract expire and only lose the $1.000 premium because of the unfavorable market movement.

Perpetual Contracts

Perpetual Contracts are different from Futures and Options agreements in several ways. First, they don’t have a fixed expiration date. Instead, a trader can keep them open indefinitely, but under one condition: the contract needs to hold a certain minimum amount of Bitcoin, called a margin.

Another vital element of Perpetual Contracts is the funding rate. Because these investment tools don’t have a set expiration time in the future, the value of the contract can greatly vary from its underlying asset. To mitigate this problem, one group of traders is required to pay a funding rate to the other group.

With Perpetual Contracts, you can either go ‘long’ or ‘short’ on an asset. If John is one of many investors who has gone long on Bitcoin, the price of the perpetual contract will significantly detach itself from the spot price of BTC. If it weren’t for funding rates, there would be no reason to hold short positions as Sara does.

This particular case is known as a positive funding rate. When it’s positive, John and others who have gone long on BTC need to pay a fee to Sara and other traders with existing short positions. This ‘penalty charge’ is meant to motivate parties to close their long positions and go short instead. This change would make the value of the perpetual contract get closer to the actual market price of Bitcoin.

The same logic would be used in a reverse scenario if the price of the Perpetual Contract were to be significantly lower than Bitcoin’s spot value. In that case, financial incentives would make traders go long instead of short.

Why Are Crypto Derivatives Useful?

Because of the volatile nature of the cryptocurrency market, additional money management tools such as crypto derivatives provide traders with an extra layer of security. We will mention two ways in which you can benefit from derivative instruments:

Hedging

You can use crypto derivatives to minimize and mitigate your portfolio losses during unfavorable market conditions. With hedging, it’s possible to short an asset. This doesn’t require the trader to liquidate the underlying asset, in our case, Bitcoin.

A short position can be opened with leverage. A 10x leverage, for example, will only cost you 1/10 of the price compared to traditional trading. Hedging is one of the ways to protect your holdings during a bear market and even make money when others are losing.

Speculation

Speculating and correctly predicting a future price of a digital asset can generate profits for those who know how to do it. If you purchase an altcoin like Ethereum just before the start of a bear market, the coin won’t bring you any profits because the price keeps going down.

But with a derivative contract, you can speculate that the price will fall by opening a short position. If Ethereum indeed loses value, you will earn money even if the underlying asset price is lower.

Where Can I Purchase Crypto Derivatives?

Crypto derivatives such as Futures, Options, and Perpetual Contracts are listed on popular cryptocurrency exchanges. CoinMarketCap has ranked the top platforms in terms of the daily trading volume. As of February 2022, the top 5 exchanges look like this:

  1. Binance
  2. OKX
  3. Bitget
  4. BitCoke
  5. FTX

Summary

Derivative crypto trading allows a trader to make money no matter the market's direction. This isn’t possible if you just buy and hold in a bear market. For example, if one BTC is worth $40.000, and its value depreciates to $35.000 in a month, you have effectively lost $5.000. But if you can predict market trends, you can use the bear market to your advantage and increase your capital.

Crypto derivatives are effective instruments because you don’t have to concern yourself with where to store the actual asset they are derived from. Not everyone wants to be their own bank and be in control of keys, recovery phrases, and other private data. You won’t deal with that with derivatives because there is only a contractual agreement between two parties.

Do your own research on what type of crypto derivative fits your needs the best and ensure that your money is invested with a reliable service provider. Priority should be given to recognized exchanges that account for high trading volumes and have proven track records.

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