Crypto Derivatives Explained: What They Are, How They Are Traded, And Their Best Practices

The global financial markets are among the most appealing and profitable industries in the world, and it is hard to ignore the burgeoning growth of the financial markets, especially with cryptocurrency becoming increasingly involved. In the midst of this revolution are crypto derivatives, another set of instruments in the financial trading market that are gaining in popularity by the day.

Crypto derivatives trading is typically more flexible and manageable than that of traditional financial instruments, since it derives its value from a primary underlying asset; in this case, crypto coins/tokens. Moreover, there are over 40 crypto-derivatives exchanges, and more than 400 cryptocurrency exchanges worldwide, making the option more widely accessible.

Interestingly, crypto derivatives have grown to such an extent that cryptocurrency derivatives trading on centralized exchanges rose to $3.12 trillion in July 2022, marking a 13% monthly increase. Reacting to this development, more traders and investors than ever before have started turning to crypto derivatives. 

Many are looking to diversify their incomes by experimenting with crypto derivatives, and requires sufficient knowledge to do so. To get started, investors must first fully understand what derivatives are, how they work, and what makes them tick. Fortunately, we have gathered all of that information in one place in the form of this article! To get started, what are crypto derivatives?

Derivatives are a financial tool used by traders and merchants as a form of security against an underlying asset with established financial value (a fixed price). 

Essentially, derivatives act as contracts between two parties that intend to trade, buy, or sell a product based on its future price. The future price depends on market fluctuations, and changes based on this benchmark. Derivatives can be anything from bonds, stocks, and interest rates, to newly available cryptocurrencies.

With that in mind, cryptocurrency derivatives are financial contracts based on an underlying asset with a fixed price. The underlying asset used in crypto derivatives trading can come in the form of any cryptocurrency token, and the two parties entering into the financial contract speculate on that cryptocurrency’s price for a future date.

During the first phase of the contract, both sides agree on a buying/selling price for the specified cryptocurrency on a pre-determined day, regardless of its market price. As a result, investors can potentially profit from changes in the underlying asset’s price due to purchasing the currency at a cheaper price, and then selling it at a higher price.

Trading in crypto derivatives is typically a straightforward process, and works by placing a long or short trade order based on where the trader thinks the price of the crypto in question will arrive. If the trader makes the right decision, they stand to make a profit, but a poorly made decision can result in significant losses.

Leverage can also be used by traders to increase their potential profits (or losses) on the positions they take. This is known as “margin trading” and allows traders to place orders larger than the funds they actually have available for trading.

Derivatives come in many forms, but there are a number of more popular formats, as listed below, that traders frequently delve into.

Futures contracts are a popular type of derivative which allows buyers the right to purchase an asset, and sellers to offload an asset at a fixed price at a future, agreed upon date. Most traders close their futures contract before the contract expires, booking their profits or losses in the process. Usually, traders use futures contracts to hedge other investments when trading in a volatile market like crypto.

Using Bitcoin as an example, if a trader believes that the price of 1 BTC could fall after crossing $18,000, as seen at the end of November 2020, the trader could utilize a futures contract as a hedge to protect their current margins. Let’s say the trader purchases a futures contract with one-month maturity, if the price were to drop below $18,000, the trader would be able to safeguard their profit. However, if the opposite is the case, the trader could stand to lose most of the gains in their Bitcoin books over the next month.

Options are another form of crypto derivative, providing traders with the option, or right, to either buy or sell an underlying asset at a set price at a specified future date, however, the trader does not necessarily have to exercise their right to take action. In this way, the contract simply gives the trader the option to buy or sell at a certain price and date, but doing so is not mandatory when the allotted time comes.

Through options trading, investors don’t choose whether to go long or short, but rather “call” and “put” options. A call option gives the investor the right to purchase an asset, and conversely, a put option confers upon them the right to sell. With either option, the trader is in control of whether to exercise the right. However, keep in mind that options are not free of risk.

Perpetual contracts operate without specific settlement dates, enabling traders to keep their positions open for as long as they desire, in line with certain conditions. One such requirement is that the account must maintain a minimum level of the selected crypto as a margin, while another thing to consider is the funding rate, which is the unique mechanism that serves to tether the contract’s price to the crypto itself.

Forwards are similar in style to futures contracts. The major distinction is that forward contracts relate to over-the-counter trade exchanges, as opposed to centralized exchanges. The benefit of this is that interested parties can customize their buy-and-sell contracts. Despite its flexibility, traders should be aware that the lack of centralization makes trading forwards a riskier prospect than some other derivatives formats.

Leverage tokens are derivatives that apply leveraged exposure to market risks, liquidity, and margins. The token’s price will therefore depend on the existing supply, demand and market price of the derivative.

Here are some of the reasons for why so many modern day traders are interested in crypto derivatives:

1. Low Transaction Costs: Derivative contracts aid in reducing market transaction costs, since they are risk management instruments. Hence, the cost of a transaction in derivatives trading is lower than in other securities, such as spot trading.

2. Liquidity: Crypto derivatives typically attract professional and institutional traders who contribute to the liquidity of the crypto market. Increased liquidity means more buyers and sellers in the market, allowing for more transactions to take place.

3. Market Efficiency: Derivative trading involves arbitrage, which is essential for ensuring that the market achieves equilibrium, and that the prices of underlying assets are correct.

4. Risk Management: The values of derivative contracts are innately tied to their underlying assets. For this reason, derivatives are used to mitigate the risks associated with the fluctuating prices of those assets. For example, if a trader purchases a derivative contract, and the underlying asset’s price falls, the losses incurred can be offset against the gains from their derivatives.

5. Portfolio Diversification: Crypto derivatives offer traders more options to diversify their investment portfolios. They can expand across multiple crypto assets, and master advanced trading strategies. Some examples of the more sophisticated trading strategies are: arbitrage, pairs trading, short-selling, and more.

On the other side of the coin lay the disadvantages of crypto derivatives. Some major drawbacks to using crypto derivatives include the following:

1. High risk: Derivatives contracts are hugely volatile, owing to unpredictable fluctuations in the value of the underlying crypto coins/tokens. As a consequence, traders often run the risk of losing a lot of money.

2. Speculative Nature: Derivatives contracts are frequently employed as speculative instruments. Naturally, due to the significant risk involved, and the unpredictability of their swings in value, speculative investments can result in huge, unforeseen losses.

3. Regulatory Issues: Although the U.S. regulates crypto derivatives trading, there are still some countries around the world in which derivatives trading remains illegal, and banned outright. For example, in 2020, the UK imposed a ban on the sale of cryptocurrency-related derivatives to retail investors. This means that each of the involved parties participating in a futures contract must be operating from territories in which derivatives trading is legal.

Crypto derivatives are only useful when the traders possess deep knowledge of the market and the trades they are undertaking. However, they offer a great opportunity for both newbie and experienced crypto investors to diversify their portfolios and generate extra income.

The form of financial instrument comes in a variety of forms, including futures, options, forwards, and perpetual contracts, each of which has its own set of conditions and requirements to fulfill. Prospective traders are free to choose from the many varieties discussed in this article, but should always remember that any investments made should be based purely on risk tolerance. Good luck out there!