Due to its many possibilities, crypto derivatives have gained popularity among individual and institutional traders in recent years. It has many potential benefits as well as some risks. Understanding what they are and how they work is a good step in determining if they’re right for you.
What are crypto derivatives?
Derivatives are contracts whose values depend on the value of another underlying asset. Thus, crypto derivatives derive their values from the underlying crypto asset. In the derivatives market, traders leverage their holdings, speculate on the price direction of the underlying crypto asset, and hedge positions.
The derivatives market allows you to either buy a crypto asset at a lower price and sell it back at a higher price in the future or sell it at a higher price and buy it back later and still make a profit. If, for example, the price of Bitcoin is $15,000 and you believe that the price of BTC will rise to $25,000, derivative contracts allow you to open a long or long position and hold it until the price of BTC reaches $25,000.
Conversely, if you believe the price will fall from $15,000 to $12,000, you can open a sell or short position and close the contract when the price reaches $12,000; that way you will also close the trade to ensure profit even though the price of BTC has fallen.
For these two examples, trades would be closed at a loss if two contracts went against your guesses.
The derivatives market has been used as a hedge against price volatility and has enjoyed increased attention in the ever-volatile cryptocurrency market. They are traded online on many crypto exchanges and also over the counter (OTC).
4 types of crypto derivatives
In this section, we will describe the four most popular types of derivatives.
A futures contract is an agreement between two parties to buy or sell an asset at a fixed price on a specific date.
Parties can agree to buy or sell crypto in one month, regardless of the actual price. After a month, the buyer will profit if the price of the cryptocurrency rises and is higher than the agreed price. If the crypto price instead falls and stays below the agreed price, the seller will make a profit.
2. Perpetual Futures
A perpetual futures contract is simply a futures contract without an expiration date. This means that investors can hold their positions for as long as they want.
Like futures, options also allow traders to buy and sell crypto assets at a specific price at a date in the future. The main difference between futures and options is that options give buyers the right, but not the obligation, to buy the underlying asset.
Option contracts are classified into two types: call options and put options. A call option gives the right to purchase an asset, while a put option gives the right to enter into a sales contract at a certain price and period.
Futures contracts are privately negotiated contracts between buyers and sellers to trade an asset at a specified price at a future date. They are also similar to futures, with the difference that futures are traded on OTC exchanges. Futures contracts are more prone to higher risk because they lack decentralization.
Differences between derivatives and spot market
The spot market allows you to buy and sell cryptocurrencies as you wish, with the limitation that you can only profit when the price of the asset increases. If the price starts to fall, you will start losing your profit. Spot traders find periods of prolonged bear markets unsettling because it is difficult to turn a profit at such a time. Another major feature of the spot market is that you can also hold the actual assets you buy.
On the other hand, derivatives allow you to trade contracts that track the price of an underlying crypto asset, say Bitcoin, without owning it. The price of derivatives is set to be very close to that of the spot market. The market allows you to profit whether the price goes up or down.
Derivatives markets could be efficient markets during the crypto winter. However, it takes more time to master derivatives trading. Moreover, the risks involved in derivatives trading are usually higher than those in the spot market.
Advantages of trading crypto derivatives
The ability to grow your account is one of the main advantages of derivatives trading. You can trade derivatives with little capital and expect to make big profits since you have increased your buying or selling power with borrowed money, which is leverage. This advantage also makes derivatives trading easier for those with little trading capital.
As the crypto market becomes more popular, many people are looking for ways to take advantage of its high price volatility to make more profits since they can make money regardless of the direction of the market if they are in the right position. Therefore, derivatives serve as a speculative market to mitigate risk, especially during large price fluctuations.
The derivatives market allows you to access the crypto market without holding crypto. It also allows for easy diversification, as you can profit from the price movements of different asset classes without holding.
Disadvantages of trading crypto derivatives
Derivatives use speculative tools, and price movements can be very unpredictable. Therefore, making irrational decisions can result in significant losses.
Derivatives traders are subject to short-term price manipulation in the crypto market. Many of their trades are short-term, and since most market manipulations affect short-term market movements, they could affect their positions. It gets worse when positions are leveraged.
Over-the-counter derivatives, like futures, have a higher chance of counterparty risk. One of the parties involved might not fulfill the agreement because the contracts are usually made privately and are not regulated.
Is crypto derivatives trading right for you?
Below are some questions you need to answer to determine if crypto derivatives trading is a good option for you.
1. Do you agree with the risk involved?
The derivatives market is suitable for traders with a high risk appetite. Traders with a low risk threshold may not be comfortable trading derivatives.
2. Do you understand how the market works?
You should understand the factors that cause price changes in the crypto market. Each financial market has unique factors that cause price changes and influence movements. Similarly, every market also has a unique movement pattern, popularly known as price. Understanding how they work helps you make easy guesses about price direction.
3. Do you know how to conduct a trade analysis?
Trading on the derivatives market is much more complex than on the spot market. You need a good understanding of technical analysis to analyze price action, fundamental analysis to predict the long-term outlook of a crypto project’s price, and sentimental analysis to know what the general market sentiment is and how it may affect the market.
Derivatives trading is suitable for both new and experienced traders. You can choose any of the available options based on your preference and best understanding. Derivatives trading is, like all other types of trading, risky; you should always take steps to manage your trades and make only informed trading decisions.