What Are Cryptocurrency Derivatives

What Are Cryptocurrency Derivatives

Experienced investors use special financial instruments to capitalize on the volatility of the digital money market. Such tools help with less risk to earn on Bitcoin and altcoins. Derivatives have become one of these tools in the cryptocurrency (and global financial) world. They are the best means of hedging and managing financial risks by improving liquidity and pricing during free exchange trading.

In this article, we will talk about Bitcoin and overall cryptocurrency derivatives and answer the following questions:

  • What are crypto derivatives? 
  • Are derivatives in the crypto world profitable?
  • What are derivatives used for? 
  • Are there any cryptocurrency derivative trading platforms? 

Crypto Derivatives Explained

A derivative is a financial contract for the future price of a cryptocurrency, security, product or service. The subject of such an agreement is called the underlying asset. Sellers and buyers of derivatives do not own the underlying assets but sell and buy the right to execute the contract.

There are many types of derivatives, the main ones are futures, options, and swaps. 

Futures is an agreement on the sale or purchase of an underlying asset at an agreed price in the future (hence the name). For example, you order specific vehicle equipment at a car dealership. It will be delivered in six months, and you will be required to buy a car at the agreed price.

Option is a contract that gives the buyer the right, but not the obligation, to buy goods at an agreed price. 

There are two types of options. Call, which gives the right to buy (its price increases with the growth of the cryptocurrency rate) and Put, which gives the right to sell (its price increases with the decrease in the rate of the digital coin).

For example, you ask to hold the goods until tomorrow, because you do not have any money with you. Options trading options are provided by Deribit and LedgerX.

Swap is two contracts. One is the purchase and sale of an underlying asset and the second is the purchase and sale of the same asset in the future. This is a more complex version of the futures. For example, you buy a specific configuration of a car, but at the same time agree with a friend that you will sell this car to him at a higher price.

How Crypto Derivatives Appeared

Futures are characteristic of the cryptocurrency market. Why did they appear there? 

In December 2017, Bitcoin reached a record value of $20,000, and public investment in ICOs turned into a hobby of any investor. Over the past 4-5 years, many centralized exchanges have sprung out of nowhere and have provided powerful tools and opportunities for absolutely anyone to invest in innovative and useful projects. The user-friendly interface and low entry price instantly attracted millions of people. Thus, exchanges have provided great accessibility to cryptocurrency trading.

Soon people understood that centralized exchanges were vulnerable due to their centralization. Crypto and blockchain pioneers did not expect that the cryptocurrency market mechanism would be based on several exchanges with staggering earnings on commissions (up to $3 million daily) and without guarantees of the complete safety of personal funds. The crypto community is periodically shocked by the news about hacker attacks on exchanges and wallets. 

All these precedents exposed traders and ordinary wallet holders to great vulnerability. The solution to this problem was decentralization. However, decentralized exchanges have not taken root on the market because of their complex technical implementation and the high cost of projects. If we talk about derivative financial instruments, then so far only a few decentralized exchanges are available to professional traders and all of them are quite immature projects with many shortcomings.

Where to Get Crypto Futures

The two most well-known platforms for acquiring bitcoin futures are Chicago CBOE Options Exchange and Chicago CME Commodity Exchange. On CBOE, one futures is equal to one Bitcoin. On CME, one contract is equal to the value of five bitcoins. 

When dealing with futures, you can open long and short positions. In the first case, the trader agrees to buy the asset at a certain price in the future, in the second – to sell the underlying asset on the day the contract expires. All futures contracts have margin requirements.

Margin is the minimum amount of funds required to open and maintain a position on a futures contract. Margin is required for both parties to the contract (both for the buyer and seller of the futures). Access to the CBOE and CME exchanges can only be obtained through brokerage companies that have special licenses.

daily trading volume derivatives
Daily Average Derivatives Volumes in 2019

Small investors can work with Bitcoin futures on platforms such as BitMEX, OKEx, Crypto Facilities. These sites provide the trader with leverage. 

Leverage is the ability to use borrowed funds when trading. 

Such a loan allows you to make transactions with a value in excess of equity in the account of the trader. The platform pledges a part of the investor’s funds and provides him with a loan to open a position. It adds equity to transactions. The size of the leverage is proportional to the deposit made by the trader and depends on the specific platform. Basically, the sites provide leverage with the commission.

If a trader has concerns that Bitcoin has begun to decline, then he can sell futures, for example, on the BitMEX platform, with leverage of 1:10. 10% of the initial investment is an additional amount that is necessary to balance the position. If the fears of a decrease in the underlying asset are justified, then a 10% pledge with tenfold leverage compensates for the loss. 

When the recession period ends and prices begin to recover, a short futures transaction can be closed. In this situation there are risks some: there was no recession, futures went negative, and the trader closed the sale at a loss, without waiting for the liquidation of the contract. However, it is worth noting that in this case the loss is limited by the amount of the collateral and its maximum is known in advance.

Are Crypto Derivatives Profitable

Traders earn on changing the price of the underlying asset. Since the future market price of the underlying asset is unknown, all bidders take the risk. If at the time of execution of the contract the goods fell in price, the seller receives the profit, and the buyer remains at a loss. If the product has risen in price, then the buyer remains the winner.

How Cryptocurrency Derivatives Affect the Market

On the day of the launch of futures on the Chicago CBOE options exchange, the price of bitcoin increased by more than $1000 in one minute. A similar jump in the rate was recorded when the derivative was launched on CME. 

cboe bitcoin futures trading

By tracking the number of contracts sold, you can predict the course of Bitcoin. If a large number of large players simultaneously sell on BTC futures, then it is likely that the market will sag. If they buy, then perhaps the course will go up. Large-scale operations indicate a general level of interest in the first cryptocurrency, which may affect the value of the asset.

Derivatives stimulate price increases, reduce volatility and attract institutional investors to the industry. However, despite all the advantages and the fact that one of the main tasks of these financial instruments is to reduce investment risks, derivatives do not guarantee stable income and constant profit, and so far remain an instrument for experienced traders and major industry players.