What Are Crypto Derivatives? 4 Types of Derivatives Explained
Reading Time: 5 minutesThese follow the price of an underlying crypto asset without owning it.
Due to their numerous opportunities, crypto derivatives have gained popularity in recent years among individual and institutional traders. It has a lot of potential benefits, as well as some risks. Understanding what they are and how they work is a good step in determining if they are suitable for you.
What Are Crypto Derivatives?
Derivatives are contracts whose values depend on the value of other underlying assets. Thus, crypto derivatives get their values from an underlying crypto asset. In the derivatives market, traders leverage their holdings, speculate on the price direction of underlying crypto assets, 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, derivatives contracts allow you to open a long or buy position and hold it till the price of BTC gets to $25,000.
Conversely, if you believe that the price will drop 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 be closing the trade to secure a profit even though the price of BTC dropped.
For the two examples, the trades would be closed at a loss if the two contracts went contrary to your speculated direction.
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 four of the most popular types of derivatives.
1. Futures
A futures contract is an agreement between two parties to buy or sell an asset at a fixed price on a certain date.
The 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 crypto price increases and is higher than the agreed price. If the crypto price goes down instead 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 desire.
3. Options
Like futures contracts, options also allow traders to buy and sell crypto assets at a specific price on a future date. The main difference between futures and options is that options give buyers the right but not the obligation to buy the underlying value of an asset.
Options contracts are classified into two types: call options and put options. The call option gives the right to buy assets, while the put option gives the right to enter into a selling agreement at a specific price and period.
4. Forwards
Forwards are privately negotiated contracts between buyers and sellers to trade an asset at a specified price on a future date. They are also similar to futures, with the difference being that futures are traded on OTC exchanges. Forward contracts are prone to more risks since there is a lack of decentralization.
Differences Between Derivatives and Spot Market
A spot market allows you to buy and sell crypto as you wish, with the limitation that you can only profit when the asset price increases. If the price starts to drop, you will begin to lose your profit. Spot traders find periods of prolonged bear markets distressing because making a profit at such a time is difficult. Another major feature of the spot market is that you can also hold the real asset you buy.
On the other hand, derivatives allow you to trade contracts that follow 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 regardless of whether the price increases or decreases.
Derivatives markets could be effective markets during the crypto winter. However, it requires more time to master how to trade derivatives. More so, the risks involved in trading derivatives are usually higher than those in the spot market.
Advantages of Trading Crypto Derivatives
The opportunity to leverage your account is one of the major advantages of trading derivatives. You can trade derivatives with little capital and expect to make a lot of profit since you have increased your buying or selling power with borrowed money, which is leverage. This edge also makes it easier for those with little trading capital to trade derivatives.
As the crypto market becomes more popular, many people are looking for ways to exploit its high price volatility to get more profit since they can earn no matter the market direction if they are in the right position. Thus, derivatives serve as a speculative market to mitigate risk, especially during high price fluctuations.
The derivatives market allows you to access the crypto market without holding any crypto. It also allows for easy diversification, as you can profit from different asset classes’ price movements without holding any.
Disadvantages of Trading Crypto Derivatives
Derivatives use speculative tools, and price movement can be very unpredictable. Thus, making irrational decisions can result in significant losses.
Derivatives traders are susceptible to short-term crypto market price manipulation. Many of their trades are short-term, and since most market manipulations affect short-term market movement, they could affect their positions. It becomes worse when the positions are leveraged.
Derivatives traded over the counter, like forwards, have a higher chance of counterparty risk. One of the parties involved could default on the agreement since the contracts are usually privately negotiated and unregulated.
Is Crypto Derivatives Trading Suitable for You?
Below are some questions to answer in determining if crypto derivatives trading is a good option for you.
1. Are You Comfortable 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. Every financial market has unique factors that cause changes in price and affect movements. Similarly, every market also has a unique pattern of movement, popularly known as price action. Understanding how they work helps you to speculate easily on the price direction.
3. Do You Know How to Carry Out Trade Analysis?
Trading in the derivatives market is a lot more complex than in the spot market. You need a good understanding of technical analysis to analyze price actions, fundamental analysis to predict the long-term prospect of a crypto project price, and sentimental analysis to know what the general market mood is and how it can affect the market.
Manage Risk
Derivatives trading is suitable for both new and experienced traders. You can choose any of the available options based on which you prefer and understand best. Derivatives trading, like all other types of trading, is risky; you should always take measures to manage your trades and make only informed trading decisions.
Reference: https://www.makeuseof.com/crypto-derivatives-explained/
Ref: makeuseof
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