An Introduction to Crypto Derivatives: Types and Features

An Introduction to Crypto Derivatives: Types and Features

Crypto derivatives are financial instruments whose value is derived from an underlying asset, in this case, cryptocurrencies. They provide an opportunity for traders and investors to bet on the price movements of cryptocurrencies without actually owning the underlying assets.

Think of it as betting on the outcome of a sports game. Just as you might bet on a team to win, you can bet on the price of a cryptocurrency to go up or down. Instead of physically owning the cryptocurrency, you are holding a contract that gives you the right, but not the obligation, to buy or sell the cryptocurrency at a predetermined price.

In simple terms, crypto derivatives are a way to bet on the future price of cryptocurrencies and potentially make a profit without actually owning the underlying assets.

What are the most common types of derivatives in crypto?

The most common types of crypto derivatives are:

1. Futures: Futures are contracts that allow traders to buy or sell an underlying asset, such as a cryptocurrency, at a predetermined price on a future date. They are used to speculate on the price movements of cryptocurrencies or to hedge against price fluctuations. Exchanges such as LBank offer an innovative futures trading suite that enables users to experience the complete dimension of derivatives trading.
2. Options: These are contracts that give traders the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time frame. Options are often used to hedge against price fluctuations or to speculate on the future price movements of cryptocurrencies.
3. Swaps: Swaps are agreements between two parties to exchange one asset for another, usually at a future date and at a predetermined price. In the context of cryptocurrencies, swaps are used to exchange one cryptocurrency for another.
4. Perpetual swaps: Perpetual swaps are a type of derivatives that function similarly to futures but without an expiration date. They allow traders to take a long or short position on the price of a cryptocurrency without the pressure of expiration.
5. Synthetic tokens: These are digital assets that are designed to track the price of an underlying asset, such as a cryptocurrency. They allow traders to take a position on the price movements of the underlying asset without actually owning the asset.

What are the major features of derivative trading?

The key features of derivative trading are:

1. Leverage: Derivatives allow traders to increase their exposure to the market without putting up the full amount of capital. This is achieved through leverage, which is the use of borrowed funds to amplify one’s potential gains.
2. Margin trading: Derivative trading typically involves margin trading, where traders are required to post a portion of the total value of their position as collateral. This collateral acts as a guarantee for the funds borrowed, allowing traders to trade with larger positions than they could with their own capital.
3. Short selling: Derivatives allow traders to take short positions, which allow them to profit from price decreases. This is in contrast to traditional investing, where traders can only profit from price increases.
4. Futures contract expiration: Futures contracts have an expiration date, which is the date on which the contract must be settled. This creates a sense of urgency for traders, as they must either close their positions or roll over their contracts before the expiration date.
5. Contract size: Derivatives are typically traded in standardised contract sizes, which allows for easy comparison and trading of the assets.
6. Mark to market: Derivative contracts are marked to market daily, meaning that the value of a trader’s position is revalued at the end of each trading day based on the current market price. This helps to mitigate risk, as traders must maintain sufficient collateral to cover any potential losses.
7. Liquidity: Derivatives markets are typically highly liquid, which means that it is easy to buy and sell contracts in large quantities without significantly affecting the market price. This high liquidity makes it easier for traders to enter and exit positions quickly and efficiently.

What are the purposes of crypto derivative trading?

Derivatives trading in crypto are used for the following:

1. Speculation: Derivatives allow traders to speculate on the future price movements of cryptocurrencies. By taking a long or short position on a cryptocurrency’s price, traders can potentially profit from price movements in either direction.
2. Hedging: They can be used to hedge against price fluctuations in the underlying asset, such as a cryptocurrency. For example, a trader who holds a large amount of a particular cryptocurrency can use derivatives to protect against a potential price drop.
3. Increased leverage: It allows traders to increase their exposure to the market without putting up the full amount of capital. This is achieved through leverage, which is the use of borrowed funds to amplify one’s potential gains.
4. Diversification: Derivatives provide traders with an opportunity to diversify their portfolios. By trading in different types of derivatives, traders can spread their risk across multiple assets, reducing the overall risk of their portfolio.
5. Price discovery: Derivatives can be used to determine the fair market value of an underlying asset, such as a cryptocurrency. By analysing the prices and volumes of derivative contracts, traders can gain insights into the market sentiment and demand for a particular asset.

What are the key differences between the spot market and derivatives market?

Here’s a table summarising the key differences between the spot market and derivatives market:

Conclusion

Crypto derivatives come in various forms and offer traders the ability to speculate on price movements, hedge against price fluctuations, increase leverage, diversify their portfolios, and determine the fair market value of an underlying asset. However, it’s crucial to understand the underlying mechanisms and risks involved in derivative trading, as well as to trade within one’s risk tolerance. By carefully considering the features and benefits of derivative trading, crypto traders can make informed decisions and potentially maximise their returns while minimising their risks.

Disclaimer: The opinions expressed in this blog are solely those of the writer and not of this platform.