The cryptocurrency market can be divided into spot trading and derivative trading. Today, we shall be focusing on what are crypto derivatives and how they can be used.
What are derivatives?
First things first. What is a derivative? A derivative is defined as a financial contract between two or more parties, which 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 as an underlying asset anything from currencies, cryptocurrencies, commodities, bonds, stocks, market indexes, and interest rates.
Derivatives can be traded in two 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 when it comes to 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.
There are various kinds of crypto derivatives, which can be traded either on traditional exchanges or regulated crypto exchanges.
A futures contract is a financial contract established between two 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 quite appropriate considering the volatility of cryptocurrencies. Thus, by signing a contract which directly settles the price of a underlying crypto, traders are able to mitigate the risk by trading Bitcoin and altcoin futures.
The first Bitcoin futures were offered by Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (CBOE) on 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 which currently offers Bitcoin futures is the CME Group, as CBOE has not added new contracts since March.
Bakkt, an institutional crypto platform, was set to launch its Bitcoin futures trading several times but has finally set the testing date for the product on July 2019.
CFD (Contracts for Difference)
A CFD is an agreement based on an underlying crypto which contracts to pay the owner the difference between
the price of the underlying asset at the beginning of the contract and the price at the end of the contract. 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.
Trading platforms which 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.
Swaps are a type of crypto derivatives which enables 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, adding 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 OKEx also offers futures as well as perpetual swaps trading, which is a contract that has no expiration date, with 100x leverage. The contracts can be made with several crypto assets including Bitcoin, Ether, EOS, and even the new USDK stable coin.
The options contract is an asymmetrical derivative which binds one party while the other party is decided at a later date i.e. when the option expires. This means that one party is obligated either to buy or sell at a later date whereas the other party has the option to make his choice. Obviously, the one that 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 owner of the contract can be on the long side or the short side of either the put or call option.
Options are also traded on exchanges. LedgerX is an exchange which offers crypto options.
The Disadvantages of Trading Crypto Derivatives
All trading strategies that are based on price fluctuations carry a certain degree of risk. Like wit 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 margin with high leverage.
The regulatory aspect is another issue with crypto derivatives. Regulators in different countries have different legislation when it comes to crypto futures and other types of derivatives based on crypto.
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.
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