What Are Financial Derivatives?

Financial derivatives is a concept corresponding to the basic financial products, which refers to the derivative financial products based on the basic products or basic variables, whose price changes with the price (or value) of the basic financial products.

Features of Derivatives:

1. Derivatives can be used to hedge risks or speculate on the directional movement of an underlying asset.

The original purpose of financial derivatives was to hedge against risks, but then its high leverage and wide variety of transactions made many traders and institutions enter the market to speculate and seek high returns.

2. Zero sum game or even negative sum game

As the derivatives transaction does not need physical objects, it only needs two counterparties, so the profit and loss are completely negatively correlated. The income of one party comes entirely from the loss of the other party, but due to the transaction cost, it can also be considered a negative sum game.

3. Usually with leverage, the risk and return are higher than the general financial products

Because derivatives are usually traded with margin, and margin financing and short selling with the assistance of exchange,leveraging a position that several times higher than the margin can be operated, and the risk and earnings are amplified.

4. The rules of each product are different, so the threshold is relatively high

Derivatives have a much higher entry level compared to spot trading due to its availability of high leverage and for the smooth operation of the market and various mechanisms.If you are not familiar with the rules, it may cause a large loss of funds and even the position will return to 0.

What are the most popular types of derivatives in crypto?

1.Perpetual Contracts

Perpetual contracts are similar to traditional futures contracts, but unlike futures or options, perpetual contracts have no expiration or settlement date. Therefore, users can hold positions indefinitely, which is very similar to spot trading. The biggest difference between contract trading and spot trading is that contract trading does not really own the underlying assets. For trading perpetual contracts, users only need to keep an eye on buying in rising or buying in lowering, which is convenient in operation experience, and you can trade with leverage of up to 100 times on some of Gate.io contracts.

Perpetual contracts use marked prices and capital rates to help them operate. The marked price is a weighted price based on the external market, and its purpose is to reduce the unfair liquidations that may happen when the market is highly volatile. The fund rate is a balance mechanism based on the price difference between the perpetual contract price and the spot price, which can effectively narrow the price difference between the perpetual contract price and the spot price.

Example: Bitcoin is $20,000 at the current market price

Use spot trading:

If Alice held one bitcoin in a spot trade,with the price of $20,000, when Bitcoin rises by 10%, the price will come to $22,000, and Alice will gain 10% benefit.

Use perpetual contracts:

Taking advantage of the easy and highly leveraged nature of the contracts, if Alice chooses to buy Bitcoin of margin3xLong and buys a contract with 3 BTCs and a value of $60,000, it will increase by 10%, and the contract value will be $66,000. Compared with spot trading, the use of perpetual contracts has a 30% benefit.

Although the high leverage of the contract has increased Alice’s benefits, it is only because she sees the market direction correctly. If she chooses the wrong direction, the loss will also enlarge.

Similarly, when $20,000 falls by 10%, the price will drop to $18,000.

Alice held one BTC because of her participation in spot trading. The price fell by 10%, and the loss was only 10% of the principal.

The perpetual contract was leveraged three times, the price fell by 10%, representing a decrease from $60,000 to $54,000, and the loss of $6,000 was 30% of the principal.

Because of the high leverage of contracts and the high volatility of the market itself, senior traders usually set profit and stop loss prices and abide by strict trading rules and frameworks.

Although perpetual contracts are similar to spot transactions, they are still slightly different (see the chart below).

2.Delivery Contracts

Delivery contracts are contracts of traditional futures trading to complete the purchase and sale of the underlying assets at the agreed price on the future delivery date. Unlike perpetual contracts, delivery contracts have a clear delivery date. When the delivery contract expires, both the buyer and the seller of the contract are obliged to perform the contract and complete the delivery. If the settlement price is higher than the position-opening price, the buyer will gain profits; If the settlement price is lower than the position-opening price, the seller will gain earnings.

For example:

If the buyer and the seller agree to trade 10 BTCs at the price of $30,000 on July 31, 2022. On that day, no matter if the market price rises or falls, both parties are obliged to complete the transaction with the other party. When the time expires, it will be settled automatically, so it is impossible to hold positions for a long time.

If the settlement price is greater than $30,000, the buyer will gain profits: if the settlement price is less than $30,000, the seller will gain profits.

3.Options

The biggest difference between options and traditional futures trading is that in the transaction of delivery contracts, the buyer and the seller have equal rights and obligations. However, in options trading, the buyer has the right to execute the contract and has no obligation to perform. In addition to the deposit, the seller also has the obligation to perform the contract.

The main reason is that the buyer of the options, that is, the right holder, pays the premium to obtain the right. If the market is inconsistent with the direction of judgment, he/she can give up his/her right; The seller of the options, who collects the premium, undertakes the performance obligation and pays the deposit, has limited income and unlimited potential risks.

Due to the different rights and obligations of the buyer and the seller, the options seller bears the obligation to be performed. When the price changes adversely, the loss may be much greater than the royalties it collects.

4.Callable Bull/Bear Contracts (CBBC)

Callable bull/bear contracts are not cryptocurrencies, stocks or bonds, but derivative instruments with leverage and automatic stop loss mechanisms. Buying callable bull/bear contracts is like financing to buy or short the linked underlying matter. With a small amount of financial related fees, investors can expand the leverage ratio and earn the price difference.

If investors are bullish on Bitcoin, they can directly buy the “callable bull contracts” linked to Bitcoin. If they are bearish, they can buy the “callable bear contracts”. It should be noted that the callable bull/bear contracts have a forced recovery mechanism. When the price of the underlying asset of the callable bull/bear contracts touches the recovery price, the callable bull/bear contracts will be forcibly recovered and cannot be traded. It can be considered a forced stop interest (stop loss) mechanism to avoid the expansion of losses.

5.Structured Finance Products

New financial products that combine the features of fixed income bonds and derivatives

Structured financial products with fixed income plus selling options have income much higher than the fixed interest rate, but the income comes from the premium after selling options. Therefore, it needs to bear the risk of token rise and fall of future generations after performance. It is a financial product without principal guaranteed nature.

Sharkfin is a principal guaranteed financial product composed of fixed income products and knock-out options.

By setting the price range and knock-out price, as long as the price is within the range within the subscription period, investors can get high returns, but once they touch the knock-out price, the options will expire. Although unable to obtain high income, they still enjoy fixed interest income.

Precautions for using financial derivatives:

1. Margin and liquidation price

Because when using many derivatives, only a part of the margin needs to be provided to the exchange, the position value several times that of the margin can be operated for trading. The liquidation price is the marked price when the value of the margin is insufficient to cover the loss of the position value. Once the marked price starts, the position will be overloaded, and all the margin will be confiscated.

Users should pay attention to the risks caused by leverage. If they think the leverage is too large, they can add margin at any time to reduce the leverage.

2. Cross mode and Isolated mode

The difference between the cross mode and the isolated mode lies in the collateral used as margin.

Cross mode refers to the use of all collateral in the account as margin, and all positions share margin.

Isolated mode uses part of the margin in the account, and each position is independent.

Therefore, if the current market is fierce and the crypto price fluctuates greatly, once a position touches the liquidation price in the cross mode, all positions will be closed; Few positions will be overloaded in the isolated mode, and the position holders will not be affected.

3. Fund rate

The fund rate is a unique and exclusive mechanism of perpetual contract in crypto space, which aims to make the contract price close to the spot price. When the fund rate is positive, long-position holders shall pay to short-position holders; When the fund rate is negative, short-position holders shall pay to long-position holders.

Although the amount of one-time payment of fund rate is small, if it is paid continuously for a long time, the total amount of the final payment may reach 10% or even higher of the position. Therefore, it is necessary to pay attention to the positive and negative of the fund rate to avoid the continuous loss of principal.

4. Liquidity

For highly-liquid derivatives, the transaction time and the transaction cost caused by the price slide are quite small. However, if the liquidity of the instruments used is poor, it may occur that the transaction cannot be successfully concluded, and the transaction cost may be higher than expected due to the increase of real-time trading or sliding price.

How to choose suitable derivatives?

Derivatives usually have the features of fighting for the big with small ones. Therefore, we often hear that someone uses high leverage to directly earn wealth without worrying about food and clothing for a lifetime. This kind of situation belongs to survivor bias. The derivatives market itself is a zero sum game. Where we can’t see it, many people borrow and use highly leveraged derivatives. Instead of making profits, they have to bear debts that will take decades to repay.

In addition to doing deep and careful research, investors also need to understand the rules of derivatives, and also need to take their own risk acceptance into account.

Age, financial status, mental status and other factors should be taken into account in the assessment, which will affect your risk acceptance ability.

People aged 20 and 60 may have completely different risk acceptance:

Young people will think that they still have time to fight, so they are willing to accept greater risks.

60-year-old investors may be more willing to conduct conservative trading and financial management because of their aging body and poor working ability compared with young people.

In terms of financial status, investors with relatively abundant cash flow will also have higher risk acceptance ability than those with relatively poor cash flow.

Although derivatives provide high leverage, you can still keep yourself away from excessive exposure risks by depositing more margin or actively reducing the leverage ratio.

Conclusion

The trading market of crypto space has developed rapidly in recent years, from the initial fiat trading and crypto trading to the subsequent development of unique perpetual contracts. Institutions and talents from all parties have entered the market one after another, and the demand for derivatives is also increasing.

Many people are fascinated by the characteristics of high leverage, but at the same time, many people think its risk is very high and are unwilling to participate. The original intention of derivatives was to avoid risks, and speculation was given by later traders.

The quality of an instrument is not given by its characteristics. Instruments are just instruments. There is no good or bad, only whether they can be used. Making good use of instruments can even get more benefits and rewards under low-risk conditions, but using instruments you don’t know may hurt yourself.

Before trading derivatives, you must assess your risk acceptance ability and master the knowledge of the product. Proper control leverage and allocation of margin can achieve the purpose of position control.