Have you ever heard of crypto derivatives? There are various forms of crypto derivatives available but are they profitable? How to trade them?

The big rise in the value of Bitcoin has put the cryptocurrency market on the radar of many small and big investors. Since its first release in 2009, the crypto has surpassed great heights in value and price. It is now the biggest cryptocurrency with over $1 trillion in value.

While Bitcoin still dominates the market at the moment, there are over 5,000 other digital currencies or more commonly known as altcoins. However, many people are still unaware of these currencies. Although not all of them are necessarily revolutionary or bear many utilities, they definitely have proven to be a significant improvement to Bitcoin and the market itself.

The Complete Guide of Crypto Derivatives

In other words, the growth in the cryptocurrency market is incredible even though the asset is relatively young and new compared to other products in the industry. Along with the development of the coins themselves, we can also find various innovations in the system that directly affects how crypto trading works. One of the most recent yet booming additions to the crypto market is trading crypto by using derivatives.

 

What is Crypto Derivative?

A derivative is a financial contract or agreement between two or more parties based on a future price of an underlying asset. It is worth noting that the derivative itself has been around for a very long time, rooting back to medieval times, where derivatives were used among merchants to facilitate their trades in periodical fairs as the early form of the market at the time.

Derivatives then have evolved over the centuries until they become one of the most popular financial tools. Nowadays, a derivative is commonly used as a form of security that derives its value from an underlying asset. The contract can be signed by two or more parties who want to buy or sell that particular asset for a specific price in the future. The contract's value then will be determined by the market's fluctuations.

The most common assets for derivatives are currencies, bonds, and commodities. A crypto derivative would use a cryptocurrency like Bitcoin as the primary asset. Considering the high volatility of the crypto market, using a derivative may be a great option to improve your trades greatly or even multiply your profits by a mile.

 

Crypto Spot Vs. Derivative

Typically, traders do their transactions in the BTC spot market, where they can purchase and sell Bitcoins at any time. But remember that such a market comes with certain limitations. The most obvious one is that you can only make a profit when the market price goes up. The idea is to buy BTC when the price is low and then sell it if the price is high.

So if the price drops, anyone holding a BTC will face the risk of a value decrease in their investments. Even if you manage to sell it before the significant downturn and intend to buy back when the price is low, you still need the price to go back up again. Other than that, spot markets also force you to hold to your Bitcoin in order to stay in the game.

Meanwhile, people can trade contracts on the Bitcoin derivative market without having to actually own the coin. So it doesn't come as a surprise that in recent years, derivatives are primarily discussed in the crypto market. 

 

How to Trade Crypto Derivatives?

With the increasing fame of cryptocurrency, traders began to see an opportunity to improve their trading. Derivatives are mostly used as a form of hedging in order to mitigate the risk of losing. So, signing a contract to buy or sell an asset at a specific price would help to reduce the risk. With the right analysis and strategy, traders would be able to predict how the price changes over time and take advantage of it.

Typically, traders would try to gain profit by buying a cryptocurrency when the price is low and sell it sometime later when the price goes higher. However, this strategy only works in a bull market where price keeps going higher and higher. This is quite risky as crypto's price is volatile and can quickly go in the opposite way.

Crypto derivatives trading means you can short the asset easily, which is a way to make a profit even during a bear market. In short, traders would borrow the assets from a third party (either an exchange or broker) and then sell them on the market when the price is decreasing. As the price keeps going down, the trader would purchase the same quantity of assets back for a low price and profits from the price movement. In return, the exchange or broker gets paid for commission.

 

What are the Common Forms of Derivatives?

Here are the lists of derivatives common forms:

 

Futures

A crypto future is a contract between two or more parties to purchase and sell the crypto at a predetermined price on a specific date in the future. Neither party is obliged to actually hold the crypto, but they simply settle the contract in USD or any other agreed currency. Traders can trade the futures in exchange so it is usually standardized. The unique feature of futures that distinguishes them from other derivatives is the specific settlement date.

So how do we trade with the crypto future? The first thing to learn is the duration of the contract. Exchanges usually offer various options such as weekly, bi-weekly, quarterly, etc. Let's say you want to trade weekly BTC contracts, and each contract is worth $1 of BTC when the price is at $10,000. To open a position that is worth 1 BTC, you would need 10,000 contracts.

The next thing to consider is your action. You can either go long (bet that the price will go up) or short (bet that the price will go down). Whichever you choose, the exchange will match you with someone that chooses to go in the opposite direction. A week later, when the due time comes, one of the traders must pay the other based on the price value.

See also: Bitcoin Price Today

 

Forward

Forward is very similar to futures. The only difference is that forward normally traded on over-the-counter (OTC) exchanges. Therefore, this type of contract is more flexible and customizable for the needs of both traders. However, risk factors should be considered.

 

Options

Options grant the trader the option or right to either purchase or sell the underlying asset at a certain price and at a specified future date. That being said, the trader does not necessarily have to use their rights to take action. So, the contract only gives the trader the option to buy or sell at a certain price and date, but it is not mandatory to use when the time comes.

With options, you won't be choosing to go long or short but "call" and "put" options. A call option would give you the right to purchase an asset and conversely, a put option would give you the right to sell. With either option, it is entirely up to you whether you want to exercise your right or not. However, keep in mind that options are not free of risk. Each option comes with its own price called premium, which varies based on market conditions. When a trader lets their option expire without using their right to buy or sell, they will lose whatever premium they paid for the contract.

 

Perpetual Swaps/Contracts

Unlike the previously explained derivatives, perpetual contracts don't have a specific settlement date, so traders can keep their positions open for as long as they desire under certain conditions. One of those is that the account must contain a minimum amount of crypto as a margin. Another thing to consider is the funding rate, which is the unique mechanism that helps tether the contract's price to the crypto itself.

Typically, the price of futures and other derivatives will always converge with the asset's price at expiration due to its time limit. However, since perpetual contracts don't have an expiration date, their prices can start deviating significantly from the actual asset's prices. The solution to this issue is to have one side of traders pay the opposing side.

 

Where Can I Trade Crypto Derivatives?

There are two kinds of exchanges to trade crypto derivatives: centralized exchanges and decentralized exchanges.

 

Centralized Exchanges

Bybit

As one of the largest derivatives exchanges in the crypto market, Bybit's daily volume frequently reaches over $10 billion. So, liquidity is no longer an issue in this exchange. Established in early 2018, Bybit has collected more than 1 million registered users and provides service with an intuitive mobile app. To top it off, the derivative exchange supports 24/7 multi-language customer service and transparent trading conditions.

Crypto.com

It's safe to say that crypto.com has the best URL on the market right now and has one of the most diverse products in the crypto industry. These include crypto-based credit cards, collateralized loans, and a spot and derivatives exchange. The variety of tools offered in this exchange is definitely one of the best.

Over the years, Binance has proven to be one of the leading exchanges that offer access to the long tail of cryptocurrencies. As a spot exchange, Binance constantly appears on the top places to trade crypto. Recently, the company launches a new addition in their products called Binance Futures, which deals with derivative products. The exchange provides access to futures contracts and options with up to 120x leverage and instant account opening time.

 

Decentralized Exchanges

DyDx

DyDx is one of the earliest companies that offer on-chain perpetual contracts. Despite being a decentralized exchange, DyDx does own a visible order book that shows L2 data and built-in alternative charting software. Because it is Ethereum-based, traders would only have to connect their wallets to start trading.

FinNexus

Although FinNexus is not yet as popular as other exchanges, it is actually worth checking out. The exchange offers crypto options, which are still hard to find in a decentralized platform. Apart from that, the interface is also simple to use.

See also: List of Cryptocurrency Exchanges with Low Fees

 

Are There Any Downsides of Crypto Derivatives?

When it comes to crypto derivatives, the apparent issue is regarding the volatility of the market. The ups and downs of price movement can happen anytime and really fast without prior warning, making it incredibly risky for investors. Furthermore, traders can be easily exposed to the danger of drastic price movements and might end up losing their money if they're not careful. It goes without saying that the unpredictable nature of crypto's price fluctuations only adds more risk to the investments.

The risk can be significantly amplified if the trader uses leverage. Therefore, crypto derivatives trading is not recommended for inexperienced users. Beginner mistakes can be really damaging and costly. The unpredictability of crypto definitely increases the likelihood of something going wrong.

 

Bottom Line

Crypto derivative is a recent addition to crypto trading that can increase or even multiply your profit if used correctly. It comes in many forms including futures, options, forwards, and perpetual contracts. Each has its own conditions and requirements to fulfill. As the crypto market keeps expanding, the use of derivatives becomes more significant as it is tied to the price fluctuations on the market.

 

However, it is important to remember that derivatives are not exactly easy especially for beginners. Make sure to learn the essential features of crypto derivatives, follow the tutorials, practice in the demo account, and have a strong strategy in place.