Due to its numerous opportunities, cryptocurrency derivatives have gained popularity among both individual and institutional traders in recent years. It has many potential benefits and 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?
A derivative is a contract whose value depends on the value of other underlying assets. Thus, crypto derivatives derive value from the underlying crypto asset. In the derivatives market, traders use their holdings to speculate on the price direction of the underlying crypto asset and hedge their positions.
The derivatives market allows you to buy crypto assets at a lower price and sell them back at a higher price in the future, or sell them at a higher price and buy them back later and still make a profit. For example, if the price of Bitcoin is $15,000 and you think the price of BTC will rise to $25,000, the derivatives contract allows you to open a long or buy position and hold until the price of BTC reaches $25,000.
Conversely, if you believe that the price will fall from $15,000 to $12,000, you can open or short a position and close it when the price reaches $12,000; This way, even if the BTC price falls, you will close the trade to ensure a profit.
For both examples, if the two contracts go in the opposite direction you speculate, the trade will be closed at a loss.
The derivatives market has been used as a hedge against price fluctuations and is gaining traction in the volatile cryptocurrency market. They are traded online on many cryptocurrency exchanges and over-the-counter (OTC).
4 types of cryptocurrency derivatives
In this section, we will introduce 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 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.
Like futures contracts, options also allow traders to buy and sell crypto assets at a specific price at a future date. The main difference between futures and options is that options give the buyer the right, but not the obligation, to purchase the associated value of the asset.
There are two types of options contracts: call and put. A call option gives the right to buy an asset, while a put option gives the right to enter into a sell agreement at a specific price and period.
A forward contract is a privately negotiated contract between a buyer and a seller to trade an asset at a specified price at a future date. They are also similar to futures, except that futures are traded in the over-the-counter market. Due to the lack of decentralization, forward contracts are prone to more risk.
The difference between derivatives and spot markets
The spot market allows you to buy and sell cryptocurrencies as much as you want, with the restriction that you can only make a profit when the price of the asset rises. If the price starts to drop, you will start losing your profits. Spot traders find prolonged bear market periods distressing because it is difficult to make a profit during such times. Another major feature of the spot market is that you can also hold the real assets you buy.
Derivatives, on the other hand, allow you to trade contracts that follow the price of the underlying crypto asset (such as Bitcoin) without owning it. The price of the derivative is set to be very close to the price in the spot market. This market allows you to make a profit, regardless of whether the price is rising or falling.
The derivatives market can be an efficient market for cryptocurrencies in winter. However, it takes more time to master how to trade derivatives. What’s more, derivatives trading is generally riskier than the spot market.
Advantages of trading cryptocurrency derivatives
Having the opportunity to leverage your account is one of the main advantages of trading derivatives. You can trade derivatives with very little capital and expect to make a lot of profit because you increase your purchasing power or sales power with borrowed money, which is leverage. This advantage also makes derivatives trading easier for those with less trading capital.
As the cryptocurrency market becomes more popular, many people are looking for ways to take advantage of its high price volatility in order to make more profits because if they are in the right position, they can earn regardless of the direction of the market. Therefore, derivatives, as a speculative market, can mitigate risk, especially during periods of high price volatility.
The derivatives market allows you to enter the cryptocurrency market without holding any cryptocurrency. It also allows for easy diversification as you can profit from price movements of different asset classes without holding any assets.
Disadvantages of trading cryptocurrency derivatives
Derivatives use speculative instruments, and price movements can be very difficult to predict. Therefore, making irrational decisions can lead to significant losses.
Derivatives traders are vulnerable to short-term cryptocurrency market price manipulation. Many of their trades are short-term, which can affect their positions as most market manipulation affects short-term market movements. The situation gets worse when the position is leveraged.
Over-the-counter derivatives, such as forwards, have a higher chance of counterparty risk. Since contracts are usually negotiated privately and are not regulated, one of the parties involved may be in default.
Is cryptocurrency derivatives trading right for you?
Here are some questions to answer when determining if cryptocurrency derivatives trading is a good option for you.
1. Are you satisfied with the risks involved?
The derivatives market is for traders with a high risk appetite. Traders with a low risk threshold may not be suitable for trading derivatives.
2. Do you understand how the market works?
You should be aware of the factors that lead to price changes in the cryptocurrency market. Every financial market has unique factors that cause price changes and affect movement. Similarly, each market has a unique pattern of movement, popularly known as price action. Understanding how they work helps you easily guess where prices are going.
3. Do you know how to trade analysis?
Trading in the derivatives market is much more complex than trading in the spot market. You need a good understanding of technical analysis to analyze price movements, fundamental analysis to predict the long-term outlook for cryptocurrency project prices, and sentiment analysis to understand what the general sentiment of the market is and how it affects the market.
Derivatives trading is suitable for both new and experienced traders. You can choose any of the available options according to your preferences and understanding. Derivatives trading, like all other types of trading, is risky; You should always take steps to manage your transactions and only make informed trading decisions.