Crypto derivatives are a crucial aspect of crypto trading and accounted for an overwhelming 78.2% of the total trading volume on centralized exchanges in July 2023, as reported by CCData.
Spot cryptocurrency trading volumes, on the other hand, experienced a decrease of 10.5% during the same period, falling to $515 billion, according to CCData’s findings.
The cryptocurrency market offers a vast array of opportunities, but its volatility can be daunting. Crypto derivatives are powerful financial instruments that unlock a new level of control and profit potential for experienced investors.
This ultimate guide to crypto derivatives explains everything you need to know, from its core concepts and different types of contracts to the different trading strategies and essential risk management techniques.
Key Takeaways
- Crypto derivatives are complex financial instruments. They are not suitable for beginners and require a deep understanding of the underlying crypto market and the specific mechanics of each contract type.
- Leverage can amplify both returns and losses. While leverage offers the potential for magnified gains, it can also significantly magnify potential losses. Utilize leverage cautiously and never risk more capital than you can afford to lose.
- Develop a comprehensive risk management strategy that includes position sizing, stop-loss orders and take-profit orders to mitigate potential losses and protect your capital.
What are Crypto Derivatives?
Derivatives are contracts that derive their value from an underlying asset, such as a stock, bond or commodity. These contracts don’t involve the physical ownership of the asset itself, but rather an agreement between two parties to exchange the asset at a predetermined price on a specific date (or fulfill other conditions).
Derivatives offer a variety of financial instruments for speculation, hedging and risk management.
Crypto derivatives function similarly to traditional derivatives, but with a key difference: their underlying asset is a cryptocurrency.
This means the contracts derive their value from the price movements of digital currencies like Bitcoin or Ethereum. While traditional derivatives might involve contracts for stocks, bonds or oil, crypto derivatives focus solely on the cryptocurrency market.
Here’s another distinction: crypto derivative markets are generally younger and less regulated compared to traditional markets. This can lead to increased volatility and potential risks.
Due to these reasons, crypto derivatives are complex financial instruments and are not suitable for beginners because they require a deep understanding of the underlying crypto market and the specific mechanics of each contract type.
Why Use Crypto Derivatives?
Crypto derivatives offer several advantages for experienced investors. This is why in July 2023, the volume of crypto derivatives skyrocketed to $3.12 trillion, highlighting the rapid growth and popularity of this asset class among traders.
It is important to understand the motivations behind the use of crypto derivatives:
Speculation on Price Movements
Unlike buying a cryptocurrency outright, derivatives allow investors to speculate on future price movements.
By going “long” on a derivative contract, an investor essentially bets that the price of the underlying crypto will increase. Conversely, going “short” allows them to profit if the price goes down. This flexibility enables investors to potentially capitalize on both rising and falling markets.
Hedging Existing Crypto Positions
Cryptocurrency markets are known for their volatility. Investors holding crypto assets can utilize derivatives to hedge their positions.
This involves entering into opposing derivative contracts to offset potential losses if the price of the underlying crypto takes an unexpected turn.
Risk Management in Volatile Markets
The inherent volatility of the crypto market can be both an opportunity and a challenge. Derivatives offer tools to manage risk by allowing investors to establish stop-loss orders or utilize other strategies to mitigate potential losses.
Types of Crypto Derivative Contracts
There are three types of crypto derivatives. Here are the different types of contracts available:
Futures Contracts
Futures contracts are agreements between two parties to buy or sell a specific amount of cryptocurrency at a predetermined price on a future date. They function similarly to traditional futures contracts, but with cryptocurrency as the underlying asset.
How Futures Contracts Work
Investors can use futures contracts to speculate on the future price movements of a cryptocurrency.
By entering a long futures contract, an investor essentially bets that the price will be higher at the expiry date (settlement date) compared to the current price.
Conversely, a short futures contract allows them to profit if the price falls by the expiry date.
For example, an investor believes the price of Bitcoin will rise in the next three months. They enter a long Bitcoin futures contract with a settlement date three months from now, agreeing to buy Bitcoin at a specific price on that date.
If their prediction is correct, and the price of Bitcoin increases by the settlement date, they can profit from the difference between the contract price and the higher market price.
Delivery vs Cash Settlement of Futures Contracts
There are two main ways futures contracts can be settled:
- Delivery: In traditional markets, futures contracts often involve the physical delivery of the underlying asset on the expiry date. However, in the crypto derivatives market, physical delivery of cryptocurrency is less common.
- Cash Settlement: Cash settlement is more prevalent in crypto derivatives. Here, the difference between the contract price and the settlement price is settled in cash instead of delivering the actual cryptocurrency.
Perpetual Swaps
Perpetual swaps are a type of crypto derivative contract similar to futures contracts, but with a key difference: they don’t have a fixed expiry date. This means perpetual swap positions can be held indefinitely and are automatically rolled over at regular intervals.
Similarities and Differences Between Perpetual Swaps and Futures
- Similarities: Both perpetual swaps and futures contracts allow speculation on price movements and offer leverage.
- Differences: Perpetual swaps don’t have a fixed expiry date, while futures contracts do. Additionally, perpetual swaps utilize a funding mechanism to maintain price parity with the underlying asset, which we’ll discuss next.
Understanding Fees in Perpetual Swaps
Perpetual swaps employ a funding rate mechanism to ensure their price tracks the price of the underlying cryptocurrency. This funding rate is paid periodically between long and short positions.
When the demand for perpetual swap contracts is higher on the long side, the funding rate becomes positive, and long positions pay short positions. Conversely, when there’s more demand for short positions, the funding rate turns negative, and short positions pay long positions.
This funding mechanism helps to maintain price convergence between the perpetual swap contract and the underlying cryptocurrency.
Options Contracts
Options contracts offer investors the right, but not the obligation, to buy or sell a specific amount of cryptocurrency at a predetermined price by a certain expiry date.
Unlike futures contracts, which obligate the holder to buy or sell at expiry, options contracts provide flexibility. Investors can choose to exercise their option (buy or sell the crypto) if it becomes profitable or let the option expire worthless if the market moves against them.
This flexibility comes at a cost.
Types of Options Contract
There are two main types of crypto options contracts:
Call Options
Call options grant the holder the right, but not the obligation, to buy a specific amount of cryptocurrency at a predetermined strike price by a specific expiry date.
Investors typically purchase call options when they believe the price of the cryptocurrency will rise in the future.
For example, an investor believes the price of Ethereum will increase significantly in the next two months. They purchase a call option with a strike price of $1,000 and an expiry date two months from now. This option gives them the right, but not the obligation, to buy Ethereum at $1,000 per unit by the expiry date.
If their prediction is correct, and the price of Ethereum surges to $1,500 by expiry, they can exercise their call option and purchase Ethereum at $1,000 (the strike price), then immediately sell it in the market for $1,500, profiting from the price difference.
However, if the price of Ethereum falls below $1,000 by expiry, the option will expire worthless, and the investor loses only the cost of the option premium.
Put Options
Put options grant the holder the right, but not the obligation, to sell a specific amount of cryptocurrency at a predetermined strike price by a specific expiry date.
Investors typically purchase put options when they believe the price of the cryptocurrency will decline or want to hedge their existing crypto holdings.
For example, an investor holds a significant amount of Bitcoin but is concerned about a potential price drop. They purchase a put option with a strike price of $20,000 and an expiry date three months from now. This option gives them the right, but not the obligation, to sell their Bitcoin at $20,000 per unit by the expiry date.
If the price of Bitcoin plummets to $15,000 by expiry, they can exercise their put option and sell their Bitcoin for $20,000 (the strike price), limiting their losses.
However, if the price of Bitcoin rises above $20,000 by expiry, the put option will expire worthless, and the investor loses only the cost of the option premium.
Understanding Option Premiums: The Cost of Options Contracts
Unlike futures contracts, which require an initial margin deposit, options contracts involve an upfront cost called a premium.
The premium represents the price paid to acquire the option contract and the right it conveys (to buy or sell at a specific price by a certain date). Option premiums are influenced by several factors, including:
- Strike Price: Options with a strike price closer to the current market price will generally have a higher premium compared to options with a strike price further away.
- Time to Expiry: Options with a longer time to expiry tend to be more expensive than options with a closer expiry date.
- Volatility: Options are typically more expensive in volatile markets, as they offer greater potential protection or profit depending on the direction the market moves.
Advantages of Crypto Derivatives
Crypto derivatives make up a greater share of the cryptocurrency market as they offer a compelling toolbox for experienced investors. Here are some of their inherent benefits:
Hedging
Crypto derivatives like futures and options contracts allow traders to hedge against price swings in the underlying cryptocurrency. This means they can lock in a price or minimize potential losses if the market goes against them.
Leverage
One of the most significant attractions of crypto derivatives is leverage. These contracts allow investors to control a larger position in the underlying asset with a smaller initial investment (margin). This leverage can magnify potential returns if the market moves in the desired direction.
However, it’s a double-edged sword, but a benefit nonetheless. If the market moves against the investor’s position, losses can be amplified as well. Responsible risk management is crucial when utilizing leverage with crypto derivatives.
Leverage allows traders to magnify their gains (or losses) by putting up a smaller amount of capital upfront. This can amplify returns for those who are correct about price movements.
Increased Liquidity and Market Efficiency
Crypto derivative markets often boast higher liquidity compared to spot markets (where investors directly buy and sell cryptocurrencies). This translates to tighter bid-ask spreads, meaning the difference between the price a buyer is willing to pay and the price a seller is willing to accept is smaller.
Tighter spreads make it easier for investors to enter and exit positions efficiently, especially for larger trades. Additionally, derivative markets can contribute to price discovery by attracting more participants and facilitating informed price movements.
Derivative trading, through a process called arbitrage, helps ensure markets reach equilibrium and asset prices are accurate. This benefits everyone participating in the market.
Access New Assets/Markets
Crypto derivatives can provide access to assets or markets that might not be readily available otherwise. This opens up more trading opportunities for investors.
Speculation on Price Movements
Derivatives can be used to speculate on the future price of a cryptocurrency. This allows traders to profit not just from prices going up, but also from anticipating prices going down (through shorting).
Disadvantages of Crypto Derivatives
From November 2021 to June 2022, a 22-year-old investor encountered significant financial losses totaling $80,000 as a result of engaging in cryptocurrency margin trading. The losses comprised $30,000 of his initial investment and an estimated $50,000 in potential profits that were not realized. Margin trading in cryptocurrency involves leveraging borrowed funds to acquire an asset.
Here are some of the disadvantages of crypto derivatives:
High Volatility
The very thing that makes cryptocurrencies potentially lucrative (wild price swings) can be disastrous with derivatives. The amplified gains with leverage can also lead to amplified losses, making it very risky for beginners.
Regulatory Uncertainty
Crypto derivatives are a relatively new financial instrument, and regulations are still being formed in many countries. This uncertainty can create an unstable environment for traders.
Counterparty Risk
Crypto derivative contracts rely on the counterparty to fulfill their obligations. If the counterparty (like an exchange) defaults or goes bankrupt, you could lose your entire investment.
Liquidity Issues
Crypto derivative markets, especially for less popular coins, can be illiquid. This means it might be difficult to enter or exit a position quickly, potentially amplifying losses.
Complexity and Potential for Misunderstanding
Crypto derivative contracts can be intricate and have hidden fees, especially for those unfamiliar with traditional derivatives. Understanding the terms and conditions fully is crucial before entering into any derivative contract.
The terms, strategies, and risk factors involved can be complex and require in-depth understanding. It’s essential for investors to thoroughly educate themselves before venturing into crypto derivatives to avoid misunderstandings and potential losses due to misuse.
The Risk of Leverage and Margin Calls
As mentioned earlier, leverage can be a tempting tool for amplifying returns. However, it comes with a significant risk: margin calls. When using leverage, investors are required to maintain a minimum equity threshold in their account (known as margin maintenance).
If the market moves against their position and the value of their collateral falls below this threshold, they will receive a margin call.
This forces them to either deposit additional funds or liquidate their position to meet the minimum margin requirement. In a highly volatile market like cryptocurrency, margin calls can happen quickly, leading to substantial losses if not managed carefully.
Trading Crypto Derivatives: A Practical Guide
In 2022, cryptocurrency losses increased significantly, particularly due to the Terra and FTX collapses. According to Statista, the average value lost in 2022 was around five times higher than losses incurred in 2021.
Having grasped the core concepts and different contract types, explore the practicalities of trading crypto derivatives.
Choosing a Crypto Derivatives Exchange
The first step is selecting a suitable crypto derivatives exchange. Not all cryptocurrency exchanges offer derivative products. Here are some key factors to consider when choosing an exchange:
- Regulation: Opt for a reputable exchange that operates under clear regulations. This helps ensure transparency, security, and potential dispute resolution mechanisms.
- Fees: Compare the trading fees, margin interest rates, and withdrawal fees charged by different exchanges. Crypto derivative trades often involve higher fees compared to spot trading, so understanding the fee structure is crucial.
- Liquidity: Ensure the exchange boasts sufficient liquidity for the crypto derivative contracts you intend to trade. High liquidity translates to tighter bid-ask spreads and smoother order execution.
Funding Your Margin Account and Understanding Margin Requirements
Since leverage is a key feature of many crypto derivatives, understanding margin requirements is essential.
Most exchanges require investors to deposit a certain percentage of the total contract value as margin to initiate a leveraged position. This margin acts as a security deposit to cover potential losses. Here are factors to consider:
- Funding Your Margin Account: You’ll need to fund your margin account with the necessary capital (crypto or fiat currency) to meet the margin requirements for your desired position size.
- Margin Requirements: These requirements vary depending on the exchange and the specific contract. A higher margin requirement translates to less leverage and vice versa. It’s crucial to understand the margin requirements before entering a trade to avoid potential margin calls.
Essential Order Types for Crypto Derivatives Trading
Effective order placement is paramount in crypto derivative trading. Here are some essential order types to understand:
- Market Orders: These orders instruct the exchange to execute your trade immediately at the best available market price. This is suitable for situations where you prioritize getting in or out of a position quickly.
- Limit Orders: These orders allow you to specify the price at which you want to buy or sell a derivative contract. Your order will only be executed if the market price reaches your designated limit price. This offers more control over your entry and exit points.
- Stop-Loss Orders: These are essential risk management tools. A stop-loss order automatically exits your position once the price reaches a predetermined level, limiting potential losses in a volatile market.
Risk Management Strategies for Crypto Derivatives
Crypto derivatives offer immense potential, but they also carry significant risks. Here are some crucial risk management strategies to employ:
- Position Sizing and Capital Allocation: Only allocate a small portion of your overall crypto portfolio to derivative trading. This helps mitigate potential losses and protects your capital.
- Setting Stop-Loss and Take-Profit Orders: Utilizing stop-loss orders is vital to limit downside risk. Additionally, consider setting take-profit orders to automatically lock in gains when the market reaches your target price.
Advanced Concepts in Crypto Derivatives
Explores some advanced concepts in crypto derivatives, geared towards experienced investors with a strong understanding of the fundamentals.
Basis Trading and Arbitrage Opportunities
Crypto derivative markets, like other financial markets, can present arbitrage opportunities for those adept at identifying price discrepancies. Here is a glimpse into two such strategies:
Basis Trading
Basis trading exploits the difference between the price of a futures contract and the spot price of the underlying cryptocurrency.
This difference, known as the basis, can fluctuate due to factors like supply and demand, funding rates, and market sentiment. Basis traders aim to capitalize on these fluctuations by entering positions that profit when the basis converges towards its expected value.
For example, imagine a situation where a Bitcoin futures contract expiring in three months is trading at a premium of $500 compared to the current spot price of Bitcoin.
A basis trader might believe this premium is too high and unsustainable. They could enter a long spot position (buying Bitcoin) and a short futures contract (selling the futures contract) to profit if the basis narrows over time.
Arbitrage Opportunities
Cryptocurrency markets can exhibit temporary inefficiencies between different exchanges. Alert investors can exploit these price discrepancies through arbitrage techniques.
This involves simultaneously buying a cryptocurrency on one exchange at a lower price and selling it on another exchange at a higher price to capture the difference.
However, arbitrage opportunities are often fleeting, requiring swift execution and potentially high trading volumes to be profitable.
Important Note: Both basis trading and arbitrage strategies are complex and involve substantial risks. They require in-depth market knowledge, rapid execution capabilities and a strong understanding of the underlying mechanics.
Using Options for Complex Strategies
While basic call and put options offer valuable tools, experienced options traders can utilize more complex strategies by combining different option contracts. Here are two examples:
- Spreads: Spreads involve entering simultaneous positions in two or more option contracts on the same underlying asset but with different strike prices or expiry dates. These strategies can be used to define risk and potentially profit from specific market movements (e.g., bullish or bearish price movements, limited price ranges).
- Straddles: A straddle is an options strategy involving buying both a call option and a put option with the same strike price and expiry date. This strategy profits if the price of the underlying asset moves significantly in either direction (up or down) from the strike price by expiry. Straddles are a way to hedge against uncertainty about the direction of the market but come at a higher cost compared to buying a single call or put option.
Conclusion
Crypto derivatives offer a vast array of opportunities for experienced investors. This guide has equipped you with a foundational understanding of these powerful instruments, from core concepts like futures, perpetual swaps and options contracts to practical considerations for trading and essential risk management strategies.
Start small and gradually gain experience. Don’t dive headfirst into large derivative positions. Begin with smaller trades to gain experience and confidence before increasing your exposure. Continuously educate yourself and stay informed on new developments, market trends and potential risks.
