Beginners’ Guide: What actually Is a Crypto Derivative?
A cryptocurrency derivative is a financial contract that has a cryptocurrency as its underlying asset. They can be used to hedge your investments, leverage your position, or help you make a profit no matter what happens in the market. In this blog post, we'll take a look at what they are, and how you can use them to your advantage in crypto trading.
How Do Cryptocurrency Derivatives Work?
How do you profit from an asset without buying the asset? The answer is - by transacting in derivatives. In the financial world, this form of trading is a way to make money by making predictions on what will happen to an asset, without direct exposure to the underlying. This concept has existed ever since 600 BCE and now, there is a large number of assets investors can trade on. One reason derivatives trading has become so popular is because they can be used to hedge different positions. We’ll look more into that in this article, but before we do, let’s define derivative trading in the crypto space.
What is Crypto Derivative Trading?
Crypto derivatives follow similar market principles as spot trading but instead of the underlying the investors transact in the contract. The derivative contract is usually set at a specific price and time at which the settlement trade will have to occur. The derivative gets its value from the underlying asset. However, owning crypto derivatives does not translate to owning cryptocurrency. The most common form of crypto derivatives is Bitcoin futures.
How big is the derivative market in crypto?
Interest in crypto derivatives is high. In January, CryptoCompare stats showed that trading volumes in the crypto derivatives were over the $3 trillion mark in January 2022, exceeding the spot trading volumes.
Which Types of Derivatives Are Most Popular in Crypto?
1. Crypto Futures
Futures are an agreement between two parties (a buyer and seller) to sell a cryptocurrency for a price and at a set time. The details of the contract can be flexible but in reality, they tend to be similar across different crypto exchanges.
Let’s take Ethereum as an example.
At $10,000 per ETH, Jade predicts a decrease in the price of Ethereum to $9,500 in the next seven months, after using several indicators. If Jade sells an Ethereum futures derivative contract and the value of the underlying crypto coins reduces to $9,000 at the expiry (in those seven months), he has made a $1,000 profit. In the same way, if the price of Ethereum rises to $11,000, Jade would realize a loss of $1,000. It’s important to note that derivative contracts usually trade at different prices than the spot market, especially when speaking of long expiries.
2. Crypto Options
Crypto options and crypto futures trading are two very similar contracts. The only thing that differentiates the two is that in the crypto futures, the buyer or seller is under compulsion to fulfill the trade irrespective of how unfavorable it seems, but in the crypto options trading, the buyer may decide against buying the crypto asset. To compensate for the buyer’s right to redeem the asset, a premium is paid to the seller at the moment of exchanging the contract. If the buyer eventually does not exercise this right, the seller gets to keep the underlying asset and the premium. For the American option type, a buyer may exercise before the expiry date, but the other type, the European contract (more popular amongst crypto traders), only triggers upon reaching the expiry date.
For example, Jade decides to buy a Bitcoin call option contract with a $40,000 strike price and 30 Dec expiry at a premium of $3,000. If the price of Bitcoin is $45,000 at the expiry (30 Dec), he makes a $5,000 profit, but from which he needs to deduct the $3,000 he paid in premium, hence netting $2,000 from the trade. On the contrary, if the price of Bitcoin is less than $40,000 at the expiry, he loses only the premium. Therefore, the maximum loss for options buyers is capped at the premium paid for the contract while the maximum profit is uncapped.
The situation is very different for options sellers. While they pocket a premium right upon selling the contract, they potentially face infinite losses (call sellers) if the price of the underlying goes against them. For this very reason, options traders tend to structure their positions by buying/selling multiple options (possibly even futures or spot) in order to limit the risk while maximizing the profit potential.
3. Perpetual Contracts
Another name for the perpetual contract is the perpetual swap. It has the features of the crypto futures trading, but only differs in that it does not have an expiry date. The buyer can hold the trade for as long as they want, but in return, he has to pay a particular amount called the funding rate.
The funding rate was introduced to keep the perp contract price as close as possible to the price of the underlying. When the contract trades above the spot, buyers pay the funding rate to sellers and it works the other way around if the price of the perp is below the spot value.
The Benefits of Trading Crypto Derivatives
Hedging
Derivative contracts are useful for managing risk in the markets. They allow investors to hedge their exposure to the underlying by limiting losses an asset owner can incur. Further, large asset owners (say miners) can lock in the price for which they sell their assets in the future, hence guaranteeing them a certain amount of future profit without taking risks on the market.
Increased Leverage
The demand for crypto derivatives is at an all-time high and has been increasing rapidly. Research shows that the market alone reached $600 billion in daily volumes last year, with more institutional investors attracted to this sector of finance as well.
An Efficient Market
Derivatives provide investors with an opportunity to trade on margin, meaning they need less capital to gain desired exposure to an asset. In other words, this is also called leverage trading.
High Liquidity
The demand for crypto derivatives is at an all-time high and has been increasing rapidly. Research shows that the market alone reached $600 billion in daily volumes last year, with more institutional investors attracted to this sector of finance as well.
The Risk of Trading Crypto Derivatives
A Higher Level of Risk
It's always important to be aware of the risk when trading derivatives because markets can turn quickly. The value fluctuates depending on what kind of asset it is that your contract involves, and worse still, in leveraged contracts, you're susceptible to amplified losses if things go wrong.
Lack of Due Diligence
The lack of due diligence in OTC derivative trading can lead to counterparty risks. You cannot effectively run a check on the other party because these transactions don't always stick strictly to compliance procedures, so there is more risk than with exchange-traded contracts!
Crypto Derivatives Exchanges
Same as crypto spot exchanges, derivatives exchanges are typically split into 2 categories - centralized and decentralized ones. Decentralized exchanges allow investors to trade trustlessly, but at the same time suffer from long execution times and enormous fees. On the flipside, centralized exchanges offer low latency trading with favorable trading fees, sometimes paying out rebates to makers.
Redot centralized exchange: the Redot derivatives market is still in the works. It will offer bespoke approaches to hedge positions, leverage, and speculate at will. The system is robust and resilient due to microservice-based infrastructures and it will offer both futures and options markets.
Ribbon decentralized exchange: Ribbon offers a novel approach to trading crypto derivatives via a retail-friendly solution. Their smart contracts platform allows investors to pool funds similarly to what Uniswap does and earn passive income via Ribbon’s structured product strategies.
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.
