Derivatives are financial instruments (contracts) whose values are generated from an underlying asset (e.g., Bitcoin, gold, or even potatoes), and which keep some of their price value even after some time has passed.
A derivative is simply any product or contract whose value is determined by an underlying asset. Derivatives derive their value from assets such as equities, bonds, interest rates, commodities, fiat currencies, and cryptocurrencies in traditional financial markets, hence the name.
In the same way that traditional derivatives work, a buyer and a seller engage in a contract to sell an underlying asset. These assets are sold at a defined time and price. As a result, derivatives lack inherent value and rely on the value of the underlying asset. For example, an Ethereum derivative is dependent on and draws value from the value of Ethereum.
When someone trades derivatives, they are effectively purchasing and selling contracts that represent the underlying asset. A contract, in turn, denotes the opportunity (Options trading) to buy/sell the asset at a fixed price and time in the future.
What Types Of Crypto Derivatives Are There?
There are generally five types of crypto derivatives available, which are as follows:
Futures
Crypto futures are currently the most dominant crypto derivative. Both the buyer and seller are required to acquire or sell the underlying asset when the time arrives under a futures contract. They do not don’t have a withdrawal option.
Swaps
As the name implies, payment for a cryptocurrency is made only in another cryptocurrency. Bitcoins, for example, are purchased by paying an equal amount in altcoins (like Ether).
Forwards
Forwards are contracts that can be tailored to the needs of the trader. This is typically done through over-the-counter (OTC) exchanges. Risk considerations should also be taken into account.
Options
Just like Futures, in Options, the transaction occurs in the future with a predetermined price. However, if the buyer/seller does not wish to proceed with the contract, there is no duty to do so. There are two subcategories in Options trading and they are
Call: It grants the right to purchase (The price of the asset increases depending on the growth in the cryptocurrency rate
Put: It grants the ability to sell (The price increases with the decrease in the rate of the digital coin)
Perpetual
This resembles a modification more so than a specific derivative kind. With the use of this, perpetual futures, perpetual options, or perpetual swaps are possible. There is no contract expiration date, which is a benefit. In exchange for reserving the asset for a predetermined amount of time, the buyer must pay a premium.
Understand With A Practical Example
Imagine Elena is required to spend 1 ETH on a costume for Christmas. But it's been a couple of months since Christmas. Now, Elena doesn't want to purchase the costume. Elena also believes that the cost of the outfit will go up on Christmas. She, therefore, requests the shopkeeper to sign a futures contract stating that she will purchase the costume on Christmas at the current price.
The shopkeeper predicts that the price of the costume will fall on Christmas because the majority of clients will have already purchased their costumes. So he agrees since he will make more money this way. However, he requests a non-refundable upfront payment of 0.1 ETH to reserve the costume till then. Fast forward to Christmas, and one of two things will happen.
Case 1: Price rises to 2ETH
Elena is relieved that she will only have to pay 1 ETH now that they have entered into a formal contract. Included with the 0.1 ETH advance. So she received an outfit worth 2 ETH for 1 ETH. This is known as a futures contract, and the seller/buyer cannot back out even if the seller is losing money.
Case 2: Price drops to 0.5 ETH
If they had a Futures contract, Elena would have to pay 1 ETH for an outfit that sells for 0.5 ETH. However, if she had signed an options contract, she may have chosen not to purchase the costume. The vendor would keep the 0.1 ETH advance as a non-refundable sum.
This is the distinction between an options and a futures contract. If Elena wants to buy the outfit next year rather than now, she can pay another non-refundable 0.1 ETH advance. This is referred to as a Perpetual Contract.
Perks Of Crypto Derivative Exchange
Margin Trading (Higher Leverage)
Derivatives trading necessitates a small percentage of the whole trade (10% or less). The investor can utilize leverage to increase his/her profit margins without having to pay a significant amount of money upfront.
High Liquidity
Derivatives trading markets are in high demand. According to research, daily crypto derivatives transactions surpassed $600 billion in May 2020, gaining traction with increased interest from institutional investors. With such active activity, traders have more opportunities to employ a variety of trading methods in order to optimize their earnings.
Low Commission
Derivatives trading is less expensive, with lower commissions and execution fees.
Provides Diversification
Because derivatives trading takes into account the underlying asset prices up front, they assist investors in reducing portfolio risk. Furthermore, the derivatives market is useful for generating market movement signals.
Volatilities Protection
Derivatives are great for lowering long-term price volatility in cryptocurrency by executing a contract that settles directly to an underlying price.
Excellent For Hedging
Derivatives provide a viable risk-management tool for investors looking to protect their money. A trader can avoid the majority of downside risks by thinking about two-way hedging.
How To Effectively Trade Crypto Derivatives?
The first step for investors who want to trade crypto derivatives is to sign up for a crypto exchange or a standard exchange that offers crypto derivatives trading. Here is a step-by-step procedure that a cryptocurrency trader must follow.
- Compare the features provided by various cryptocurrency exchanges, such as margin, settlement period, maker/taker fees, and any applicable withdrawal limits. Select a cryptocurrency exchange that offers the best value for the fees it costs. Remember that reputation is also important.
- Open an account with a cryptocurrency exchange, complete KYC, and fund the account with fiat or cryptocurrencies.
- Concentrate on the cryptocurrency derivatives that the trader is interested in trading. Learn how margin works and select a margin rate. First, new investors should use a minimum margin.
- Make a marginal deposit to purchase futures contracts.
- Keep the futures contracts until the expiration date. Close the trade before the maturity period ends and book profits or losses.
Conclusion
Crypto derivatives trading provides various opportunities for growth to the proper trader. The trick is to plan ahead of time before diving into crypto derivatives. Before making the initial trade, a trader should analyze and comprehend the risks connected with derivatives trading.
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