Since the advent of cryptocurrencies, various crypto derivatives have emerged. Their functions, risks and benefits vary widely. Here we examine the most important instruments and their differences.
Before we jump into the world of crypto derivatives, we need to establish an understanding of what derivatives are. A derivative is simply a financial contract between two or more parties that derives its value from an underlying asset. Derivatives do not have inherent or direct value by themselves. The value of a derivative contract is based purely on the expected future price movements of the underlying asset, which can be a tradable financial instrument of various types including stocks or commodities.
In the case of cryptocurrency derivatives, the underlying asset is, of course, a cryptocurrency. The sellers and buyers of the contract do not exchange the actual cryptocurrencies, but rather the right to execute a contract. Crypto derivatives come in different shapes and sizes.
Types of crypto derivatives
There are three main types of cryptocurrency derivatives: futures, options and swaps. Let’s look at them in greater detail.
Futures represent a contract agreement for the sale or purchase of a cryptocurrency at a future date at a predetermined price. Cryptocurrency futures are the most popular types of cryptocurrency derivatives currently trading in the markets.
Options, unlike futures, do not impose any obligations. They only give a right to exercise the option of buying or selling a cryptocurrency at a predetermined price in a specified timeline. There are two types of options. Call, which gives the right to buy (its price increases with the growth of the cryptocurrency rate) and put, which gives the right to sell (its price increases with the decrease in the rate of the digital coin).
Swap is a more complex version of a future. In traditional swaps, the two counterparties agree to periodically exchange fixed and floating rates over a period of time. Cryptocurrency markets have not yet seen swap instruments on exchanges, due to their complexity.
Reasons for trading in crypto derivatives
The motivations for crypto derivatives trading are multiple. Here we look at the most important aspects.
Speculation regarding the prices of cryptocurrencies is the biggest reason why traders like cryptocurrency derivatives. Traders aim for speculative profit by correctly predicting the volatile price movements of the cryptocurrencies. This allows them to make money when the asset is trading up (long) or when the cryptocurrency is trading down (short).
Investors and traders use derivatives to protect their portfolios from potential losses. It is similar to holding an insurance policy for your portfolio, which helps preserve capital in the event that trades result in losses.
Cryptocurrency traders aim to unlock bigger profits by applying leverage on their trading decisions. Leverage is the ability to use borrowed funds when trading. Cryptocurrency exchanges offer leverage as high as 125-fold.
Bitcoin futures are the most popular cryptocurrency derivatives available in markets today. They can be traded on institutional exchanges like LedgerX and Bakkt, traditional exchanges like CME and CBOE as well as cryptocurrency exchanges like Binance, Bitmex and Okex. Regulators in various countries have different views about crypto futures and other derivatives.
This article was originally published in Blocks99