Crypto Derivatives Explained

Introduction

The introduction of derivatives to the cryptocurrency market has been a significant development, offering traders and investors new opportunities for hedging, speculation, and risk management. The first Bitcoin futures contract was launched in December 2017 by the Chicago Mercantile Exchange (CME), and since then, a growing number of crypto derivatives have been introduced to the market, including options and futures contracts based on a range of cryptocurrencies and related assets.

This development has been driven by a number of factors, including the growing popularity of cryptocurrencies, the desire for new investment opportunities, and the need for risk management tools in a rapidly evolving market. However, it has also raised concerns about market manipulation, transparency, and investor protection. The largely unregulated nature of the cryptocurrency market has made it particularly vulnerable to these risks, and regulators around the world have been grappling with how best to address them.

Despite these challenges, the use of crypto derivatives has continued to grow, and they are now a significant part of the overall cryptocurrency market.

What are Crypto Derivatives?

Source: Blockchainsimplified.com - Crypto Derivatives Trading

Crypto derivatives are financial securities whose value is derived from underlying cryptocurrencies like Bitcoin, Ethereum, and others. Derivatives are contracts executed by two parties that define the terms for which payments can be made based on the underlying asset’s price.

Crypto derivatives come in a variety of forms, such as futures, options, and perpetual contacts. They enable traders to speculate on future cryptocurrency price movements without having purchased the underlying asset. This means that traders can potentially profit from cryptocurrency price movements without having to buy or sell them directly. In order to manage risk, they can also be used to hedge against price volatility. They are, nonetheless, regarded as high-risk financial instruments and might not be appropriate for all investors.

Types of Crypto Derivatives

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Futures

Futures contracts are agreements that require the buyer to buy a specific quantity of a cryptocurrency at a specified price and later date. Futures contracts can be used to control risk or to make predictions about how cryptocurrency prices will change.

For example, John buys a Bitcoin futures contract from Sarah at $65,000, believing that the price of Bitcoin will rise in three months. If the price goes up, John can sell the contract for a profit. If it goes down, John incurs a loss. Three months later, if the price of Bitcoin has increased to $80,000, John can sell the contract to another trader for a profit of $15,000, or buy one Bitcoin from Sarah for $65,000 and sell it for $80,000. If the price of Bitcoin falls to $50,000, Sarah can buy back the contract for $50,000 and make a profit of $15,000, or John can honor the contract and buy one Bitcoin from Sarah for $65,000, incurring a loss of $15,000.

Futures trading should only be done by seasoned traders who fully understand the risks involved because it can be very risky. In order to make wise decisions, traders must also do their homework and research before engaging in futures trading.

Options

Source: Markettradersdaily.com - Options Trading

A crypto option is a financial contract that gives the buyer the right to buy or sell a cryptocurrency at a set price on or before a certain date, but they are not obligated to do so.

For example, Tom purchases an Ethereum call option, which gives him the option, but not the obligation, to purchase one Ethereum for $3,000 within a month. He invests $200 in the option contract as a premium. Tom can exercise the option and purchase Ethereum at a lower price if the price goes above $3,000, potentially earning a profit. Tom can decide not to exercise the option and will only lose the premium if the price does not increase above $3,000. Tom can exercise his option and purchase Ethereum for $3,000, making a profit of $300 if the price of the cryptocurrency rises to $3,500. Tom decides not to exercise the option if the price drops to $2,000 and only loses the premium he paid.

It’s crucial to remember that trading options can be challenging and necessitates a thorough understanding of the market and the dangers involved. Additionally, the price of the underlying asset, the remaining time before expiration, and market volatility can all have a significant impact on how quickly an option’s value changes. Therefore, before engaging in options trading, traders must exercise due diligence and research.

Gate.io currently offers Options Trading to users with a safe, stable, and reliable exchange platform with one of the highest liquidity levels among all exchanges, ensuring the best trading experience possible.

Types of Crypto Options

In the world of cryptocurrencies, options can be divided into two main types: call options and put options. Call options give the buyer the right (but not the obligation) to purchase a specified amount of cryptocurrency at a predetermined price (the strike price) on or before the expiration of the option. On the other hand, put options give the buyer the right (but not the obligation) to sell a specified amount of cryptocurrency at a predetermined price (the strike price) on or before the expiration of the option.

Both call and put options can also be further categorized based on their exercise style. European options can only be exercised at the expiration date, whereas American options can be exercised at any time before the expiration date.

Perpetual Contracts

Source: Gate Learn - What Is Perpetual Futures Contract?

A perpetual contract is a specific kind of futures contract with no expiry date. It is instead intended to mimic the spot market, which means that it is traded at the market price of the underlying asset (such as a cryptocurrency), with funding rates applied on a regular basis to maintain the contract’s fair value.

Perpetual contracts are often utilized in the cryptocurrency derivatives economy and allow traders to speculate on cryptocurrency price movements without having to worry about the contract expiring. This distinguishes them from traditional futures contracts, which have a fixed expiration date and require the trader to either settle or roll the contract over to a new contract before it expires.

Perpetual contracts are settled using a funding mechanism that helps keep the price of the contract in line with the underlying assets’ market price. This mechanism involves charging a funding fee to traders who hold long positions and paying a fee to those who hold short positions. The fee is calculated based on the difference between the market price and the contract price and is paid or received by traders periodically.

For example, Jane wants to trade Bitcoin using perpetual contracts. She thinks that the price of Bitcoin will increase over the next few days, so she decides to enter a long position on a Bitcoin perpetual contract with a leverage of 10x.

At the time of her trade, Bitcoin is trading at $60,000. Jane decides to enter the trade with a margin of $1,000, which means that she is effectively trading with $10,000 (10x leverage). Her entry price for the trade is $60,000.

Over the next few hours, the price of Bitcoin increases to $62,000, which is a $2,000 increase. Because Jane is in a long position, she profits from this price increase. Her profit is calculated as follows:

Profit = (Exit price - Entry price) x Contract value / Entry price

Profit = ($62,000 - $60,000) x $10,000 / $60,000

Profit = $333.33

So, in this scenario, Jane makes a profit of $333.33 on her trade.

However, it’s important to note that perpetual contracts are highly leveraged instruments and can lead to significant losses if not managed properly. Traders should use caution and only trade with funds they can afford to lose.

Gate.io currently offers Perpetual Trading to users with a safe, stable, and reliable exchange platform with one of the highest liquidity levels among all exchanges, ensuring the best trading experience possible.

Swaps

Swaps are a type of cryptocurrency derivative contract in which two parties exchange cash flows based on various underlying assets. In exchange for receiving a floating interest rate or the actual price of a cryptocurrency, one party commits to paying the other party a fixed rate of interest on a specific date.

For example, Alice holds 1 BTC and is worried about a potential price drop. Bob holds 1 ETH and expects its value to rise. They enter into a swap contract where Alice agrees to pay Bob a fixed interest rate of 5% in USD, while Bob agrees to pay Alice the market value of 1 BTC in ETH after one month. If the price of BTC falls, Alice’s losses will be offset by the fixed interest rate she receives from Bob, and Bob can profit if the price of BTC rises.

Swaps are often used by traders and investors to manage risk, hedge against price fluctuations, and gain exposure to different cryptocurrencies.

Forwards

Forwards are a type of crypto derivative contract where two parties agree to buy or sell an underlying asset at a predetermined price on a future date. In the case of crypto forwards, the underlying assets are cryptocurrencies. Unlike swaps, forwards are typically settled at the end of the contract term by physically delivering the underlying asset.

For example, Pam wants to buy 1 BTC from Sam after six months at a fixed price of $60,000. They enter into a forward contract, where Pam agrees to pay Sam $60,000 after six months, in exchange for receiving 1 BTC. If the price of BTC rises above $60,000, Pam will have secured a good deal, while if it falls, Sam will have made a profit. At the end of the contract, Pam will receive 1 BTC and pay Sam $60,000.

Importance of Crypto Derivatives Trading

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• Price Discovery: Crypto derivatives provide a mechanism for price discovery in the market. As traders bet on the future price of a cryptocurrency, the price of the derivative can be used as a proxy for the price of the underlying asset. This helps to establish a more accurate market price for the cryptocurrency.
• Increased Liquidity: By allowing traders to bet on the price of cryptocurrencies without actually owning the assets, crypto derivatives increase liquidity in the market. This can lead to a more efficient market and better price stability.
• Risk Management: Crypto derivatives can be used as a risk management tool for investors and traders. By using derivatives to hedge their exposure to cryptocurrencies, investors can reduce their risk of losses in a volatile market.
• Access: Crypto derivatives allow investors and traders to access the cryptocurrency market without needing to buy and store cryptocurrencies. This can be particularly useful for institutional investors, who may have restrictions on holding cryptocurrencies.

Use Cases for Crypto Derivatives

• Speculation: Traders frequently use crypto derivatives to speculate on the future price of cryptocurrencies. A trader, for example, may purchase a futures contract that allows them to purchase Bitcoin at a specific price in the future. If the price of Bitcoin rises above that level, the trader can profit by selling the contract.
• Hedging: Crypto derivatives can hedge as a risk management tool. A Bitcoin miner, for example, may use a futures contract to lock in a price for their output, reducing their exposure to price volatility.
• Arbitrage: Crypto derivatives can be used for arbitrage opportunities, where traders take advantage of price discrepancies between different exchanges or markets. For example, a trader may buy Bitcoin on one exchange and simultaneously sell a futures contract on another exchange if they believe the price difference is greater than the cost of the futures contract.
• Market Making: Crypto derivatives can be used by market makers to provide liquidity to the market. By buying and selling derivatives, market makers can help ensure that there are always buyers and sellers in the market.
• Asset Management: Asset managers can use crypto derivatives to gain exposure to cryptocurrencies in a more controlled and regulated manner. A hedge fund, for example, may use derivatives to increase exposure to Bitcoin without purchasing the underlying asset.

Advantages of using Derivatives

• Leverage: Some derivatives, such as futures and options, can provide leverage, allowing traders to increase their exposure to an asset with a relatively small investment. This can amplify potential returns but also increases the risk of losses.
• Customization: Derivatives can be customized to meet the specific needs of investors and traders. For example, futures contracts can be tailored to a specific asset, expiration date, and strike price.
• Greater Efficiency: Derivatives can facilitate more efficient and cost-effective trading, reducing transaction costs and increasing market transparency.
• Tax Advantage: Certain types of derivatives can offer tax advantages over holding the underlying assets directly. For example, futures contracts and exchange-traded options are considered “Section 1256 contracts” under U.S. tax law, which means that they are subject to special tax treatment.

Risks of using Derivatives

• Counterparty Risk: Derivatives are contracts between two parties, and there is always a risk that one party may default on their obligations. This can lead to losses for the other party and can be particularly problematic if the defaulting party is a large financial institution.
• Liquidity Risk: Derivatives markets can be illiquid, meaning that it may be difficult to buy or sell a derivative at a fair price. This can be particularly problematic during times of market stress when liquidity can dry up quickly.
• Market Risk: Derivatives are vulnerable to market risk, which means that their value can rise or fall based on changes in the underlying asset’s price. This is particularly difficult in volatile markets, where price fluctuations can result in significant losses.
• Operational Risk: Derivatives trading can be complex and involve multiple parties, which can increase the risk of operational errors or failures. For example, errors in the calculation of margin requirements or the settlement of trades can lead to significant losses.
• Regulatory Risk: Derivatives are subject to regulation, and changes in regulatory requirements can affect their value and trading conditions. This can lead to uncertainty and volatility in the derivatives market.

Conclusion

The introduction of derivatives to the cryptocurrency market has opened up new opportunities for investors and traders, allowing them to gain exposure to the market without actually owning the underlying assets. While these instruments can offer significant advantages, such as increased liquidity and the ability to hedge against market risks, they also come with risks, including counterparty risk, leverage risk, and market risk.

Ultimately, the use of crypto derivatives offers a glimpse into the future of finance, where new technologies and innovative financial instruments are driving new opportunities and changing the way we think about investing and risk management. As with any new development, there are challenges and uncertainties, but for those who are willing to navigate the risks and seize the opportunities, the world of crypto derivatives offers exciting possibilities for the future.