Crypto derivatives are contracts that track the price of a cryptocurrency. They can be used in market upswings or downturns. Using crypto derivatives in tandem with a spot portfolio allows traders to hedge their risks.
- Crypto derivatives - Evolution from the spot
- Going long and short with crypto derivatives
- How to use crypto derivatives
- Hedging using crypto derivatives
Like most financial assets, the value of cryptocurrencies is based on simple supply and demand. And because of the 24/7 trading cycle, crypto prices change rapidly.
In such a scenario, holding onto cryptocurrencies carries price risk i.e. the risk that a crypto’s price might suddenly change. This makes holding a cryptocurrency on the spot market risky. A solution to hedge against the price risk in the spot market is to use crypto derivatives.
A derivative is a contract representing an underlying asset. This underlying asset can be a stock, commodity, or even a cryptocurrency. Derivatives can expire at a particular point in time or never expire and perpetually track the price of an asset.
Crypto derivatives - Evolution from the spot
Crypto derivatives are a relatively new innovation in the financial industry. They are designed to mitigate risk and give investors more control over their investments.
Crypto derivatives are traded on exchanges. These can be centralized exchanges like Density, Binance, or FTX, as well as decentralized exchanges like dYdX, Perpetuals Protocol, etc. The market data used in the contracts is based on prices from established cryptocurrency exchanges. This makes them reliable and accurate.
Traditional financial derivatives are based on the value of existing financial assets such as stocks, bonds, commodities, and currencies. Beyond these assets’ value, the derivatives have no inherent value.
Crypto derivatives work like traditional derivatives in the sense that a buyer and seller can enter into a contract to trade an underlying asset at an agreed price and at a future date. This price is agreed upon mutually by the buyer and seller and is called the “strike price.” The date at which the asset exchanges hands from the buyer and seller is called the “expiry.”
Going long and short with crypto derivatives
An interesting feature of crypto derivatives is that they track an asset’s price as it goes up or down. Compare this to a traditional spot market product. A trader willing to bet on (or in favor of) a cryptocurrency can simply buy it today and sell it when the price goes up. But if they want to bet against (or not in favor of) a cryptocurrency, there is no way they can do so in the spot market.
Enter derivatives. Derivatives, specifically perpetuals, allow a trader to bet on or against the price of a cryptocurrency. In trading terms, this is called going long (for) or short (against) on an asset’s price.
For instance, let's say Bitcoin is priced at $20,000 and a trader expects its price to go up. He can go long on Bitcoin by buying the Bitcoin perp. This way if Bitcoin rises to $21,000 or 5% up, the trader’s portfolio will rise by 5% or $1,000.
Similarly, if the trader expects the price to go down, he can take a short position by selling the Bitcoin perp. Hence, if Bitcoin falls to $19,000 or 5% down, his portfolio will rise by 5%, or $1,000.
In both scenarios, long or short, the trader did not directly buy, sell, or hold Bitcoin. He simply bought and sold a contract that represented Bitcoin’s price based on a particular price movement i.e. up (long) or down (short). This gave him exposure to Bitcoin’s rise and fall with one financial product. Pretty neat, right?
How to use crypto derivatives
First, you can use a futures contract to lock in a price for your underlying asset. This way, you can protect yourself from downside risk while still participating in the upside potential of the market.
Imagine you're a farmer and you're worried about the price of wheat going down. You can enter into a futures contract to sell wheat at a fixed price, no matter what the market price is. This protects you from downside risk but still allows you to participate in the upside potential of the market. Think of it like an insurance for your wheat crop
There are two primary types of crypto derivatives:
- Derivatives that do not have any fixed expiry (Perpetuals or Perps)
- Derivatives with a fixed expiry (Futures and Options)
A perpetual is a non-expirable derivatives contract that perpetually tracks the price of an asset. It can be either long (expecting the price to rise) or short (expecting the price to fall).
Futures are more standardized and will have a larger pool of liquidity.
Options, on the other hand, are tailor-made for specific investors and are based on a specific underlying asset, such as Bitcoin. They give you the ability to control your entry and exit into the underlying asset, while still having the flexibility to take advantage of market moves.
Finally, you can also use a variety of other derivatives contracts to hedge your portfolio, including swaps and forward contracts.
Hedging using crypto derivatives
When constructing a hedging strategy, the first thing you need to do is select your underlying asset. This is the asset that you want to protect your investment against. With crypto, your underlying asset will usually be either Bitcoin or Ethereum.
Once you’ve chosen your underlying asset, you need to identify your risk level and decide how much you want to hedge.
If you are very risk-averse and want to protect against the risk of a significant drop in value, you will want to choose a long position. If you are bullish on the price movement of a crypto asset and want to protect against a significant increase in price, you will want to choose a short position.
Hedging is a great way to protect your investment against catastrophic loss. However, it’s important to note that even if you have a hedging strategy in place, there is no guarantee that you will not lose money in the long term. Crypto is extremely risky, so your best bet is to keep your investment small and only use hedging as a resort to minimize your risk. If you’re interested in investing in crypto, it’s a good idea to start with a small amount of money that you can afford to lose.
Density is offering 10 USDT for first time traders upon completing their KYC and Bank verification. You can trade for free, don't miss out on this opportunity. Please do contact us on whatsapp +91 90350 92634 for any queries you have.
You can learn more about the blockchain industry at our Density Blogs.