Cryptocurrency derivatives, rather Bitcoin derivatives, emerged at a time when traders felt the need to hedge their assets against volatility and protect them from a downward risk. Besides, they could also use crypto/bitcoin derivatives to bet on its price and profit. With Bitcoin spots, these advantages were missing. So, cryptocurrency derivatives had to enter the scene.
In the early days buying and holding Bitcoin was the common trend as its supporters believed that its value would appreciate in the future, which it did. As a consequence, the Bitcoin spot market emerged with peer-to-peer cryptocurrency exchanges cropping up everywhere.
The launch of other big cryptocurrencies like Ethereum, XRP, LTC helped accelerate the momentum of the crypto spot trading markets. The cryptocurrency market, however, was (and still is) an emerging market characterized by heavy price fluctuations.
Avid traders realized that much more can be done beyond the buy, hold and sell strategy that was common to Bitcoin and investors could profit off of Bitcoin’s volatility. This is how Bitcoin/crypto derivatives trading found its way into the cryptocurrency space.
What is a Cryptocurrency Derivative?
To put it simply, a crypto derivative is a product that represents the value of the underlying crypto asset but is not the underlying asset itself. Crypto derivatives are only used as a speculative instruments and come in the form of a contract between two parties. This contract will be bound by terms that would have an individual sell a crypto asset to the counterparty in the future at a speculative price and vice versa.
The primary purpose of crypto derivatives is to allow traders to hedge the price of the volatile assets they hold. This is to ensure there is a steady cash flow even if the price fluctuates in the future.
For instance, if a trader thinks a crypto asset price will go down, they can decide to short (sell) the crypto to a counterparty and mitigate the risk of an overall downward risk. Similarly, traders can speculate that a crypto asset will go bullish and decide to long (buy) it at the best possible price and time.
The three major types of cryptocurrency derivatives are Future Contracts, Perpetual contracts and Options. But before we begin, let’s understand currency pairs, the major components of any crypto derivatives contract.
A cryptocurrency pair is made of the base currency and the quoted currency represented as, for example, BTC/USD, or BTC/USDT. The base currency is the one that an individual wants to trade (buy or sell) and the quote currency is the currency in which the cost would be borne.
Going by the above two examples in regards to derivatives trading, the BTC/USD pair represents a coin-margined futures contract where BTC is used as the quote and the settlement currency. On the other hand, the BTC/USDT pair is also called a USDT-margined derivatives (futures/perpetual) contract where the quote and settlement currency is in USDT, a stable coin pegged to the US dollar.
Futures are the oldest contract type in cryptocurrency derivatives trading. The contract exists between two parties. According to a crypto futures contract, a specific date in the future is fixed and a specific price of the underlying asset is predetermined. On the future date, both the parties decide to receive or sell the underlying asset at the price specified in the past. The individual who receives the asset goes long, that is, agrees to buy the asset. On the other hand, the individual who agrees to provide the asset goes short or sells the asset. Crypto futures contracts work as a hedging mechanism and benefit traders wishing to hedge their crypto exposure for a given period. Some of the advantages of futures contracts are:
- Traders can reduce the risk of facing a bigger loss from a cryptocurrency price slump by taking a short future position. Conversely, they can take a long future position to benefit from a price hike.
- For volatile assets futures can somewhat stabilize the price of the concerned asset.
Some Factors to Note Regarding Crypto Futures Contract
- The buyer or the seller pays an initial margin to open the contract.
- A maintenance margin is required to replenish the value of the contract in case the crypto asset suffers a loss.
- A call margin may require the trader to put in more margin to save the contract from getting liquidated.
Understanding Cryptocurrency Futures Contracts with Examples
Crypto futures contracts can turn in higher returns if the trade goes in favour of the speculator. However, if the opposite happens the loss would be amplified as well.
Let’s suppose a trader assumes BTC’s current rate, which is $1000 today, will be $2000 two months from now. So, they enter a Futures contract with another party with whom an agreement is signed to sell the BTC at $1500. If in reality, BTC’s price on the expiry date is $1600, the trader who went short by selling makes a profit.
On the other hand, the trader who goes long buys BTC at a lower price than the market price. If the opposite happens and BTC’s price goes down and trades at $900, the trader who goes short will still have a profit at the end of the day despite BTC’s price going down in reality.
The other trader who went long will face a loss. They might have a chance to recover their losses by entering the Futures contract of a cryptocurrency that is bullish or by waiting for BTC’s price to rise once again. But that’s a different strategy altogether.
Here’s another example, a trader may feel that BTC’s current price which is $800 today will become $500 in the next two weeks. So he/she might decide to enter a contract which is set to buy BTC at $600 after two weeks. So if BTC, in reality, does go down and trades at $550, the seller has made a profit of $50 by shorting BTC.
Advantages of a Crypto Futures Contract
Some of the advantages of crypto futures contract are:
- Traders don’t need to pay a premium. The margin is compensated if the trade turns into a profit. So, futures are more cost-efficient.
- They do not suffer from time decay as the contract must settle regardless of the market price of the underlying asset.
Disadvantages of a Crypto Futures Contract
Some of the disadvantages of a Futures contract are:
- Futures contracts do not provide buyers with the option to decline a contract if it is not profitable to buy the underlying asset on the expiry date.
- They are riskier because the risk is not capped upfront. So, if there is a huge divergence between the speculated price and the actual spot price of the underlying asset, the loss would be substantial.
In the case of a futures contract, the parties are obligated to settle the contract at the predetermined price and on the pre-decided date. With crypto options, the parties are not obligated to settle the contract. This means the seller may not sell the crypto derivative at all or the buyer may not wish to buy it at the strike price after the contract expires. The parties may also choose to settle before the expiry date if circumstances demand.
Traders can enter either a call option and earn buying rights to the crypto derivative, or apply a put option and choose to sell the crypto derivative in the future. If neither of the options come to fruition the buyer/seller only loses the premium paid to maintain the contract. Crypto options provide traders with the option to assess their losses from beforehand as they are made aware of the premium they would be required to pay.
The four positions of a crypto options contract are:
- Buying a call: Trader has the right but not the obligation to buy a crypto asset at a predetermined price.
- Selling a call: Trader has an obligation to sell the crypto asset at a predetermined price to the buyer in case they exercise the call option.
- Buying a put: Trader has the right and not the obligation to sell a crypto asset at a predetermined price.
- Selling a put: Trader has an obligation to buy the crypto asset at a predetermined price from the seller if he/she exercises the option.
The Role of Premium in a Crypto Options Contract
The Premium is the amount an option buyer pays to the option seller. A premium’s main purpose is to protect the seller in case the option is not exercised. It is paid upfront and is non-refundable. The premium amount is determined by the intrinsic value of the underlying asset in relation to the remaining time till the expiration date.
Advantages of an Crypto Options Contract
Some of the advantages of crypto options contract are:
- Premium helps capping the risk of a loss, which is one of the major benefits of a crypto currency Options contract.
- Traders have more flexibility while exercising the contract.
Disadvantages of a Crypto Options Contract
Some of the disadvantages of crypto options contract are:
- Even if you profit from a long position in an Options contract, the premium you pay gets deducted from the overall profit.
- They are not as popular as Futures contracts, thereby suffering from low liquidity.
- Options contracts suffer from a phenomenon called time decay which may hamper the actualization of profits.
Crypto Perpetual Swaps or Perpetual Contracts
Cryptocurrency perpetual swaps or perpetual contracts began their journey in 2016 as a trading instrument in the cryptocurrency exchange market. Perpetual swaps or perpetual contracts are crypto derivative products that never settle with no expiration date. There is, however, one problem: that of price determination. Since a perpetual contract will never settle, how will a crypto derivative follow its spot price? The solution comes in the form of a swap through a funding rate.
In order for the perpetual swap to stay true to the spot market value of the concerned crypto assets, traders are required to make periodic payments between each other. Traders will either pay or receive the funding depending on their positions (long or short). For instance, if on an exchange, a BTC/USDT perpetual swap is trading at a price higher than the spot market price, the long position holder (the one who has bought the swap) would pay the short position holder (the one who is about to sell the swap) to incentivize selling.
Conversely, if the perpetual swap price is lower than the spot price of a crypto asset, the short trader would incentivize the long trader to maintain the equilibrium. Most exchanges display the funding rates that are likely to accompany a perpetual swap.
Currently the trading volume of perpetual swaps stands at 180 billion with a large chunk of trading taking place on Coin-margined and USDT-margined derivatives contracts. Perpetual contracts are more suitable to Bitcoin speculative traders than futures contracts because they can hold positions for as long as they want.
C-Trade is a crypto derivatives exchange, which has three unique features to stand out of the crowd:
1. C-Trade offers up to 150x leverage on Bitcoin perpetual contracts.
2. Our exchange processes up to 10 million transactions per second.
3. C-Trade monitors for market manipulation using machine learning.
A reason a lot of traders love crypto derivatives products is because with derivatives they get a chance to increase their capital while entering a trade. To put it simply, traders having $100 can increase their capital by 5x and trade on $500 worth of crypto assets to multiply their gains. One must also remember that leverage trading is risky and traders can lose their entire margin if not careful. A take profit and stop loss trigger price must be set to trade on a leverage with caution. C-trade offers a 150x leverage on crypto perpetual contracts which is higher than the industry average.
So, after going through all the categories of crypto derivatives trading you might wonder which makes for the best derivatives trading instrument. Well, it all depends on your risk tolerance and the amount you are ready to invest or afford to lose if things do go south.
A traditional future contract does not require you to pay a premium or funding rates (if applied). The only interest you pay is the annualized basis rate, but there remains the chance of basis risk and an overall loss if your speculation goes wrong. In fact, with a crypto futures contract, there’s no way to circumvent a possible loss as you must settle the contract.
On the other hand, options provide a respite from obligated settling as traders may choose to deter from the contract terms. The only loss that traders stand the chance of suffering is the premium they pay to the seller.
Perpetual swaps involve funding rates and you would be required to pay it or (receive it) depending on the price difference between the underlying asset and the perpetual contract. The one good thing about perpetual is that they come with no expiry date. So you can bet on and gain from the price fluctuations of the crypto assets in perpetuity.
C-trade offers perpetual contracts across the world’s most popular crypto assets with a chance to convert trading costs into investments thanks to its extensive reward and promotional features. Ready to join the club? Sign up today, follow C-trade’s Twitter community for the latest updates, platform announcements and more.
Disclaimer: The content in this article comprises personal opinions and should not be construed as containing personal and/or other investment advice and/or an offer of and/or solicitation for any transactions in financial instruments and/or a guarantee and/or prediction of future performance. C-Trade, its affiliates, agents, directors, officers, or employees do not guarantee the accuracy, validity, timeliness or completeness of any information or data made available and assume no liability as to any loss arising from any investment based on the same.