What Are Cryptocurrency Derivatives?

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by Adedamola Bada · 9 min read
What Are Cryptocurrency Derivatives?
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In this guide, you’ll find out what cryptocurrency derivatives are, why the ever-growing number of investors choose to turn to this financial product and what potential it holds for the crypto space.

The advent of cryptocurrency has been a game-changer in the financial industry, ushering in problem-solving tools which use the blockchain technology to make life easier.

Despite the successes recorded by the crypto industry so far, there is a need for more sensitization to bring about greater adoption, and one way to advertise cryptocurrency more is through cryptocurrency derivatives. Presently, Bitcoin futures remain the most common cryptocurrency derivatives.

What Is a Derivative?

Experts have defined derivatives as a financial product, which could be either a contract or security, that depends on another asset to have a value of its own. Meaning that, without a stream of cash flows or another asset, derivatives are valueless.

The most common underlying assets from which derivatives gain recognition are currencies, bonds, and commodities. However, the value of derivatives is not tied solely to the elements mentioned above, as derivatives can obtain value from almost any asset in existence.

Derivatives tend to be used for good or bad. They can be used as speculative tools to ensure economic growth, and they can as well cripple a financial system. One example of the catastrophic nature of derivatives is the 2007 and 2008 subprime mortgage meltdown.

On their own, derivatives have no value. Their value is gotten from the forecasted price movements of the assets in play.

The Different Forms of Derivatives

Derivatives come in four main forms, which are: options, forwards, swaps, and futures.

Options. This contract enables a buyer or seller to make transactions with a particular asset at a pre-determined price while working with a specific timeline. The trader is not mandated to buy the asset according to the contract, which is a clear distinction between options and futures.

Forwards. Forwards is a contract that can be customized to fit the needs of the trader. This is usually conducted on over-the-counter (OTC) exchanges. Risk factors should also be taken into consideration.

Swaps. Swaps occur between two parties who come together solely to make a profit by planning an exchange of cash flows at a set time in the future. The assets usually exchanged are bonds, notes, or loans.

Futures. This contract obligates a trader to either buy or sell an asset at a pre-determined future date and price.

The Meaning of Crypto Derivative

With regards to the cryptocurrency market, derivatives are contracts signed by two or more parties to buy or sell a certain cryptocurrency asset for a set price in the future. Any changes experienced in the cost of the asset will have a direct influence over the value of the contract.

To trade exchanges, traders make use of exchanges or customer-to-customer (C2C) platforms. Though the term of use of the two methods differs, active traders still consider them important.

The Use of Derivatives in Crypto Trading

As the fame of cryptocurrency continues to spread like wildfire, traders continue to find price fluctuations profitable and strive to make the most of them.

With the introduction of Bitcoin and altcoin futures, traders got a new tool that they can use to mitigate risks by simply signing a contract. Traders see it as an opportunity to make profits by simply identifying a cryptocurrency with a low price and buying it in order to sell it when its price increases. It is noteworthy that this strategy is very risky, and if it must be used, then it should only come into play during a bullish market trend.

Traders have another strategy used for making profits called shorting. This is useful even when the market is on a downtrend. This strategy involves borrowing assets from a third party like a broker or an exchange and selling them at a point when they believe the price will fall.

When the price eventually falls, the trader buys the same amount of assets again, but this time at a lower price, and as the price fluctuates, they make profits. In return, the broker or exchange receives a commission.

Why Trading Derivatives Is Necessary

Derivatives come in handy for expert investors as an adequate financial tool based on the following reasons:

Hedging

The term hedging refers to the use of derivatives by investors to protect their investment portfolio. Investors who are careful not to lose much of their investments adopt the strategy of hedging. Another way to interpret hedging is by viewing it as an insurance policy for investments.

Having an insurance policy protects one from worries, and that is what hedging does for an investor. By using derivatives, traders can rest assured that investment risks are kept at bay.

Speculation

Derivatives also serve as a tool for speculation. Traders who practice crypto price speculation make use of derivatives to be more accurate. The entire reason for price speculation is to make gains from the price fluctuations of a crypto asset.

However, in some quarters, speculation is seen in a bad light, as it is believed that it causes more volatility to the already unstable cryptocurrency ecosystem.

Minimizing Volatility

The primary reason derivatives were created is to ensure that traders are no longer affected by market volatility. The use of derivatives will ensure that traders who previously were at the mercy of price fluctuations will now be able to protect themselves from any risk that might stem from such occurrence.

Disadvantages of Trading Crypto Derivatives

The use of derivatives in the crypto space is not regulated, and this alone portends risks.

Crypto derivatives face the challenge of volatility. The rise and fall of prices can happen at any time without any prior warning, which makes the crypto economy one big risk for investors.

Being a market with no rein, crypto traders with little or no experience stand the biggest chance of losing their investments. Adding to it, the unpredictable nature of crypto derivatives can amplify the possible damage. This is why a full understanding of the trading platform and all its features is a must. Users ought to complete all tutorials and arm themselves with solid strategies before embarking on crypto derivatives trading.

Comparison Between Derivatives and Spot Markets

As far as cryptocurrency is concerned, there exist two main markets, and they are the derivatives market and the spot market. These two markets have characteristics peculiar to them, as explained below:

The spot market, which is also referred to as the cash market, means the market structure that ensures the speedy conclusion of transactions. During a cryptocurrency transaction, both the buyer and seller make their individual transfers with an immediate settlement of the transactions following. There is no delay in this market type as the immediate exchange of cryptocurrency occurs once the transaction is concluded.

When a cryptocurrency is purchased from an exchange, it is the spot market that is in operation at that moment because all transactions take place at the same time and also conclude at the same time.

On the other hand, derivatives are more like financial tools than assets. In the derivatives market, participants conduct transactions using contracts instead of crypto assets. The value of the contracts is linked to the crypto assets chosen.

Where Can Crypto Derivatives Be Traded?

Crypto derivatives cannot be traded just anywhere; there are dedicated platforms for it. As an investor, the best place to access derivatives for your crypto transactions is on cryptocurrency exchanges and just any crypto exchange, but one that has been tested and proven to be rewarding to its users.

Some of the exchanges that have become a favorite for derivative trading are BitMEX, Deribit, and BaseFEX. There’s one thing to take note of, and that is, derivative trading on crypto exchanges are yet to be regulated. Therefore, anyone making use of this method ought to be ready for any eventuality, be it positive or negative.

Top Derivative Exchanges

In derivatives trading, the exchange with the most liquidity tends to be a better choice for investors. The list below will reveal the top crypto derivatives exchanges:

BitMEX

When it comes to popularity, BitMEX has no rival in the crypto derivatives business. The company’s flagship product, a tool that follows the price movement of Bitcoin against USD, accounts for more than 20% of the Bitcoin/USD trading volume in the crypto market.

It is noteworthy that BitMEX only trades in Bitcoin and here are some derivative products that can be traded on the exchange: Bitcoin Cash/Bitcoin (BCH/BTC), Ethereum/Bitcoin (ETH/BTC), Ethereum/USD (ETH/USD), Litecoin/Bitcoin (LTC/BTC), XRP/Bitcoin (XRP/BTC), Cardano/Bitcoin (ADA/BTC), Tron/Bitcoin (TRX/BTC), Bitcoin/USD (BTC/USD), EOS/Bitcoin (EOS/BTC).

Deribit

Deribit offers both options and futures products and is a top competitor to BitMEX. Just like BitMEX, Deribit also operates only in Bitcoin. While BitMEX has diversified into altcoins, Deribit has stayed its focus on just Bitcoin. Deribit has an advanced options product, and its Bitcoin/USD product helps users to get a leverage of up to 100x.

BaseFEX

This crypto derivatives trading ecosystem is a relatively new one, and it aims to provide traders with a reliable, user-friendly, and transparent derivatives exchange. It supports over ten pairs, which include XRPXBT, ETHXBT, BTCUSD, and lots more.

The leverage for Bitcoin contracts on the exchange is up to 100x, while altcoins have between 20x to 50x. BaseFEX’sBaseFEX’s trading platform is equipped with a high tech market and in-depth price charts, asset position in real-time, and so much more.

Conclusion

It is no longer news that one of the active players in the 2007 global financial crisis are derivatives. It does not rule them out as important financial tools for investment risk mitigation.

The crypto market has advanced steadily since its creation, but for a long time, its users yearned for derivative products that are suited for the crypto economy.

Who knows, maybe the addition of derivatives to cryptocurrency is the missing ingredient for worldwide adoption of cryptocurrency.

However, as sophisticated as the market seems to be, let no one forget its potential to cause great harm if wrongly utilized. Therefore, traders should apply caution when dealing with derivatives to avoid losses and make profits instead.

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