What are Cryptocurrency Derivatives?

Adam Johnson

What are Cryptocurrency Derivatives? The underlying asset in crypto derivatives can be any cryptocurrency token.

Two parties that enter into a financial contract speculate on a cryptocurrency’s price on a future date. During the first phase of the contract, the sides agree on a selling/buying price for the cryptocurrency on a specific day, regardless of the market price.

As a result, investors can profit from changes in underlying asset’s price by purchasing the currency at a cheaper price and selling at a higher price. Let’s introduce the most popular cryptocurrency derivatives.

What are the most popular types of derivatives in crypto? 

The most popular derivatives in the cryptocurrency industry are options, futures and perpetual contracts.

What are crypto options? 

A trader with an options contract has the choice, but not the obligation, to purchase or sell an underlying asset at a defined future date and price. There are “call” and “put options. A call option gives its owner the right to purchase the cryptocurrency at an agreed price once the contract expires. Conversely, a put option gives its owner the right to sell.

It is important to understand that options do not offer investors a risk-free method of derivatives trading. Each option has its own price, called a premium, which varies based on market conditions. So, when a trader lets an option expire without exercising the right or buy or sell, the trader still loses whatever premium he or she paid for that option.

What are crypto futures? 

A futures contract is a legal agreement between two parties to purchase or sell an underlying asset at a specific price and date in the future. The contract is directly executed on a regulated exchange. What distinguishes futures contracts from other crypto derivative instruments is the specific settlement date.

A trader can either go “long” or “short” on an underlying asset. To go long means that the trader is betting that the price will increase. The opposite is true with going short. Whichever direction the trader chooses, the exchange essentially matches them with someone going in the opposite direction. When the contracts are settled, one of the traders will have to pay the other. For instance, if an investor chooses to go short and the price moves down, he or she earns a profit. But if the price moves up, the trader takes a loss.

What are perpetual contracts? 

Unlike futures or options, perpetual contracts have no expiration or settlement date. Under some circumstances, traders can keep their positions open indefinitely. One of these circumstances requires that the account must contain a minimum amount of margin.

Another important factor to consider is the funding rate. This is a unique mechanism that helps tether the price of the perpetual contract to the crypto asset. Since perpetual contracts do not expire, their prices can start deviating significantly from the crypto’s prices. A solution to this is to have one side of the trade pay the opposite side.

For example, if too many traders have short positions and the price of the cryptocurrency perpetual contracts is excessively below the crypto’s spot price, people would have no incentive to open long positions. Therefore, this scenario would result in a negative funding rate. When the funding rate is negative, all short positions must pay longs. This payment helps incentivize traders to close short positions and possibly open long positions to bring the price back up to match the crypto’s actual market price.

What are the advantages and dangers of using derivatives? 

Derivatives can be used in risk management. The price of the underlying crypto coin has a direct relationship with the value of a derivative contract. Therefore, derivatives are utilized to mitigate the risks associated with fluctuating underlying asset prices.

For instance, suppose an investor purchases a derivative contract whose value swings in the opposite direction of the crypto coin the investor owns. The investor will be able to offset the losses in the underlying crypto coin with gains from the derivatives.

However, derivative contracts are extremely volatile due to the fast fluctuation in the value of the underlying crypto coins. As a result, traders run the danger of losing a lot of money. In addition, derivative contracts are frequently employed as speculative instruments. There is significant risk involved and the unpredictability of their value swings. As a result, speculative investments can result in large losses or gains.

There is also an opportunity to apply leverage when investing in crypto derivatives. Leverage allows the investor to trade a position that is much higher in value than their original margin. For example, if an investor uses 10x leverage with an account with $100, the investor will be able to trade a position worth $1,000. But as always, the increased potential for profits comes with increased risk as well.

What are interest rate derivatives?

Interest rate derivatives (IRD) are based on a benchmark interest rate or group of interest rates. Traders and borrowers use them to hedge positions or speculate on movements in the market.

Cryptocurrency derivatives are risky, speculative investments. Only traders who are prepared to put their money at risk and accept losing it in an attempt to profit should consider trading them.

Adam Johnson is an editorial intern who writes for www.stockinvestor.com and www.dividendinvestor.com.

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