The cryptocurrency market can be divided into spot trading and derivative trading. Today, we will focus on crypto derivatives and how they can be used.
What Are Derivatives?
First things first, what is a derivative? Well, a derivative is defined as a financial contract between two or more parties that want to buy or sell an underlying asset for a set price in the future.
The value of the contract will be given by the changes in the underlying asset’s price.
Derivative contracts can have anything from currencies, cryptocurrencies, commodities, bonds, stocks, market indexes, and interest rates as underlying assets.
Derivatives can be traded in 2 ways: via exchanges or customer-to-customer (C2C). The latter method is, however, different when it comes to regulation and trading.
Financial derivatives have started gaining more and more popularity in the crypto industry, especially regarding futures contracts for Bitcoin.
Types of Crypto Derivatives
Cryptocurrencies are a very speculative market, with fast price fluctuations on a daily basis. Naturally, traders are looking to capitalize on these price fluctuations. By using crypto derivatives, traders can speculate the future price of Bitcoin or other altcoins and make a profit if their forecasts turn out correct.
A Bitcoin futures contract is a financial contract established between 2 or more parties in which an underlying asset, in our case, crypto, is sold or bought at a decided date in the future but at a price set in the present.
A futures contract enables investors to hedge positions and mitigate the risk of unpredictable market fluctuations, which is appropriate considering cryptocurrencies’ volatility. Thus, by signing a contract that directly settles the price of an underlying crypto, traders are able to mitigate the risk by trading Bitcoin futures.
The first Bitcoin futures were offered by the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE) in December 2017. Chicago Mercantile Exchange (CME) is currently the biggest derivatives exchange in the world, managing over 20% of the total derivatives trading volume on a global scale.
A traditional exchange that currently offers Bitcoin futures is the CME Group, as CBOE has not added new contracts since March 2019. However, in June 2023, CBOE received approval from the CFTC (Commodity Futures Trading Commission) to launch margined futures contracts for Bitcoin and Ethereum.
Bakkt, an institutional crypto platform, also launched its Bitcoin futures trading several times. The main product went live in January 2021.
CFD (Contracts for Difference)
A crypto CFD is an agreement between 2 or more parts made based on speculating on the price of certain crypto coins and tokens. When you open a CFD, you speculate if the price of the crypto will go up or down. If the contract is liquidated and your future price speculation is incorrect, you will have to sustain higher losses, as this is a leveraged product. However, if you are right, you can make significant profits.
Usually, crypto CFDs are traded in pairs, such as ETH / BTC, LTC / USDT, XLM / BTC, XRM / BTC, and many more. Similarly, you can find trading pairs made of 1 crypto and a fiat currency, such as EUR or USD. Some popular crypto / fiat trading pairs are BTC / USD, ETH / USD, LTC / USD, BTC / EUR, ETH / EUR, or LTC / EUR.
Basically, when you trade CFDs, you bid on how the 1st part of the trading pair (e.g., BTC will move against the 2nd (e.g., USD). Based on your knowledge, you can speculate on an increase or decrease in price. For instance, if you bid on a price increase and the price of the crypto truly increases, you can profit from that CFD.
Trading platforms that offer crypto CFDs are Plus500 and IG Option.
ETF (exchange-traded funds)
An ETF is a derivative contract which tracks the price evolution of a particular crypto or group of cryptos. Traders can diversify their portfolio with ETFs without actually having to buy and own the assets tracked by said ETF.
The main benefit of crypto ETFs was already mentioned: you get the chance to enter the crypto world and diversify your investment portfolio without actually buying any crypto. Furthermore, this fact comes with another significant benefit: you don’t need to pay for other products or services implied in the crypto buying process.
Basically, when you buy crypto ETFs, you are not required to sign up or buy a digital wallet for them. And this can reduce the fees or subscription you have to pay for holding some funds. Besides, crypto ETFs can offer follow the evolution of multiple cryptocurrencies, and this may turn out to be more profitable.
Exchanges that offer crypto ETFs include Huobi, OKX, Coinbase, and Robinhood. Some of the most popular crypto or crypto-related ETFs are Bitwise Crypto Industry Innovators ETF (BITQ), Amplify Transformational Data Sharing ETF (BLOK), Global X Blockchain ETF (BKCH), Siren Nasdaq NexGen Economy ETF (BLCN), and VanEck Digital Transformation ETF (DAPP).
On June 15, 2023, BlackRock, one of the largest investment companies, filed for a Bitcoin ETF. Although over 20 companies have done this before, the SEC rejected all applications. However, BlackRock’s 1st (and only) application made quite a buzz in the crypto space and not only. Many investors and experts had and still have the hope that “this time’s” a charm. It is yet to see how this application will turn out, as the SEC has recently announced that it will delay the decision until October.
Swaps are crypto derivatives that enable the involved parties to exchange their streams of cash flows from two different financial assets. For instance, at some point in time, one party may switch an uncertain cash flow, such as a floating interest rate, for a certain one, a fixed interest rate. The interest rates or the underlying currency can also be swapped as well.
Swap contracts are not traded on an exchange, as they are usually negotiated between two parties in private and mediated by an investment banker.
The first regulated institutional exchange to introduce Bitcoin swaps was LedgerX, which added the derivate contracts in October 2017. LedgerX’s trading platform can only be accessed by accredited investors and institutional clients.
There are also many other institutional exchanges that provide these types of contracts.
Crypto exchange OKX also offers futures as well as USDT-margined and coin-margined perpetual swaps trading, which is a contract that has no expiration date with up to 125x leverage. The contracts can be made with several crypto assets, including Bitcoin (BTC), Ethereum (ETH), Litecoin (LTC), Ripple (XRP), Bitcoin Cash (BCH), Solana (SOL), 1INCH, Avalanche (AAVE), and many more.
The options contract is an asymmetrical derivative that binds one party while the other party is decided later, i.e., when the option expires. This means that one party is obligated to either buy or sell at a later date, whereas the other party has the option to make his choice. Obviously, the one who makes the choice has to pay a premium for the privilege.
These types of contracts come in two forms: call option and put option. The call option gives you the right but not the obligation to purchase the crypto at a later date at a given price, while the put option gives you the right but not the obligation to sell something at a later date at a given price. Therefore, a contract has 4 options, and the contract’s owner can be on the long side or the short side of either the put or call option.
The Disadvantages of Trading Crypto Derivatives
All trading strategies that are based on price fluctuations carry a certain degree of risk. Like with spot trading, volatility is a major factor in the outcome of crypto derivatives. Crypto prices can sharply decrease or increase, and losses are multiplied whenever someone decides to trade on a margin with high leverage.
The regulatory aspect is another issue with crypto derivatives. Regulators in various countries have different legislation when it comes to crypto futures and other types of derivatives based on crypto. Furthermore, regulatory changes can impact your trading activity to surprising extents.
Crypto derivatives can be a very profitable way of gaining exposure to the digital asset market, but it is best for rookie traders to first get a good grasp on trading and investment before getting into any of these financial contracts.
However, if you pay attention to some basic tips and you always consider the risks implied by crypto derivatives, such as regulatory concerns or volatility, your trading experience should be pretty positive.