[Understanding Crypto Derivatives] A Crash Course

As digital currencies become more common as investment assets and means of exchange in financial activities, they continue to upend the economy. Crypto derivatives are a prime example of a product that has grown quickly and is still growing. And as the bitcoin business keeps expanding, a wider range of items is becoming available.

Our comprehensive guide covers and gives an understanding of crypto derivatives kinds, trading options, and trading advice, as well as their benefits and drawbacks.

What is derivative trading?

A contract or product is a derivative if its value is based on the value of an underlying asset. Examples of derivative assets include currencies, exchange rates, commodities, stocks, and interest rates. These contracts' buyers and sellers have made diametrically opposing forecasts about the price of future trade. Both parties bet on the future value of the underlying assets to benefit.

What is derivative trading in crypto?

Any cryptocurrency token may be used as the underlying asset in crypto derivatives trading. A financial contract between two parties involves speculation on the price of the cryptocurrency in the future. Regardless of market prices, the parties choose a selling or purchasing price for the cryptocurrency during the first phase of the contract. Consequently, by buying the currency at a lower price and selling it at a higher one, investors may benefit from changes in the price of the underlying asset.

How big is the derivative market in crypto?

The third quarter of 2020 saw $2.7 trillion worth of activity in the cryptocurrency derivatives market, according to Tokeninsight's Cryptocurrency Derivatives Exchange Industry Report, which is based on information from 42 exchanges. This shows the massive rise in crypto derivatives over the last years, increasing by 25.1% from the previous quarter and by 159.4% year over year from the third quarter of 2019. The value was $1.041 billion in 2019 and $2.70 billion in the third quarter of 2020.

What are the most popular types of derivatives in crypto?

Crypto derivatives can be of the following types, depending on the conditions of a contract:

1.      Futures: A futures contract is a binding contract between two parties that commits them to buying or selling an underlying asset at a given price and date in the future. Direct execution of the contract takes place on a licensed exchange.

2.      Options: With an options contract, a trader has the option—but not the obligation—to buy or sell the underlying asset at a specified price and future date.

3.      Perpetual contracts: Perpetual contracts don't have an expiration or settlement date, unlike futures or options. A trader may be able to hold onto a position forever under certain conditions (such as when the account has a specific quantity of a cryptocurrency, etc.).

4.      Swaps: A swap is an agreement between two parties to exchange cash flows based on a pre-established formula later. Like forwards, they are OTC (over the counter) transactions and are not traded on exchanges.

What are some derivative trading features?

1.      Auto Deleveraging (ADL): Your cryptocurrency exchange's ADL system will automatically deleverage an opposing position from a designated trader in the case of liquidation when a position cannot be liquidated at a price that is better than the bankruptcy price and there is not enough insurance to cover the contract loss.

2.      Stop/Loss Take Profit: It gives traders the option to define a floor price and a ceiling price for an order, enabling them to automatically quit the market when conditions are favorable.

3.      Partial Close Orders: By partly canceling their orders, it enables traders to collect partial profits while still taking advantage of the expanding market.

4.      Insurance Funds: Trades are protected from auto-deleveraging even if their holdings fall below the maintenance margin threshold.

Where to trade crypto derivatives?

On controlled and decentralized exchange systems, cryptocurrency derivatives can be traded. Exchange operators might utilize cryptocurrency derivatives exchange to connect with more investors. A crypto derivative trading platform allows you access to markets that you wouldn't otherwise have access to and is more flexible than spot margin trading.

What are the advantages of using derivatives?

1.      Low transaction costs: Derivative contracts lower the cost of market transactions since they are instruments for risk management. As a result, the cost of transaction in derivative trading is lower when compared to other securities like spot trading.

2.      Used in risk management: The value of a derivative contract is directly correlated with the cost of the underlying cryptocurrency coin or token. Derivatives are therefore used to reduce the risks brought on by changing underlying asset values. For instance, Mr. A buys a derivative contract whose value moves counter to the cryptocurrency coin or token he owns. Gains from the derivatives will allow him to offset losses in the underlying crypto currency or token.

3.      Market efficiency: Arbitrage is a necessary component of derivative trading since it helps to ensure that the market achieves equilibrium and that the prices of the underlying assets are correct.

4.      Determines an underlying asset’s price: The price of an underlying asset is commonly determined through derivative contracts.

5.      Risk may be transferred: By using derivatives, investors, businesses, and other stakeholders can transfer risk to others.

What are the disadvantages of using derivatives?

1.      High risk: Due to the underlying cryptocurrency coins'/tokens' quick value fluctuations, derivative contracts are very volatile. As a result, traders face the risk of suffering significant financial losses.

2.      Speculative: Frequently used as speculative instruments are derivative contracts. Speculative investments can occasionally result in huge losses due to the high risk they carry and the unpredictability of their value fluctuations.

Conclusion and message for the new traders

It is significantly riskier to trade derivatives than it is to just hold the underlying asset. By definition, derivatives are more erratic than the underlying asset. Derivatives are even more volatile than crypto, which is already a volatile asset class. Leverage is another feature of derivatives, which raises risks even more.

For these reasons, using derivatives is not advised for beginners or even intermediate traders. Do not utilize leverage if you are new to derivatives and want to learn and get the understanding of crypto derivatives.

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