Crypto Derivatives: A Beginner’s Guide

The crypto market has seen massive growth over the past few years. Digital currencies have become a major economic disruptor, functioning both as a medium of exchange and an asset for investment. As the cryptocurrency space continues to grow, so does the range of products offered in the ecosystem. Crypto derivatives are one such product that has seen massive growth, recently growing more than four times the size of the spot market in volume.

Below, we break down the basics you need to know about crypto derivatives.

What are derivatives?

Derivatives are part of any mature financial system. They are called derivatives because they derive their value from underlying financial assets such as bonds, stocks, commodities, interest rates, fiat currencies and cryptocurrencies.

Crypto derivatives work similar to that of the traditional financial markets. It calls for a buyer and seller entering into a contract to sell an underlying asset at a predetermined time and price. Derivatives have no inherent values, but rely on the value of the underlying assets. For example, a Bitcoin derivative derives its value from the value of Bitcoin. Derivative trades do not own or hold the underlying asset.

There are different types of crypto derivatives. Some commonly used derivatives include futures, options, and perpetual futures.

Future

Futures are one of the most popular types of crypto derivatives and are often used by institutional investors. Traders often look to futures data to predict market sentiment and future price movements.

Futures contracts are an agreement between two parties to sell an asset at a specific date in the future for an agreed amount. Although some exchanges may provide different contract details, they all work on the same premise.

Futures work by betting on possible price changes in the future. If the price of Bitcoin was $50,000, you could either sell futures (to hedge against a futures drop in price) or buy futures (to profit from a price rise). If a buyer buys a futures contract worth one Bitcoin, if the price rises to $60,000 on the closing date, they will realize a profit of $10,000. While the price had fallen to $40,000 on the closing date of the contract, they would suffer a loss of $10,000 (not including the fees to buy the contract). In the future, the parties are obliged to comply with the terms of the negotiated contract. The example above is a simple example, since many futures contracts are used, the gains and losses are generally more substantial.

Options

Options are a derivative contract that allows the trader to buy or sell a given commodity at a given price on a specific future date. However, unlike futures or forwards, options give the buyer the freedom not to buy the asset.

Options can be either call options or put options. Call options allow the trader to buy an underlying asset on a given date, while the put option allows the trader to sell the underlying asset on a specific date. There are also the American or the European options. The American options can be sold at any time even before the expiration date, while the trade for European options has to wait until the agreed date.

Options include fees to buy the contract. For example, an option may cost $1,000 to enter. Therefore, regardless of the outcome of your trade, you must pay the $1,000. If we follow the example of the futures contracts, if Bitcoin was $50,000 and you entered a call option with a strike price of $50,000 that closed in a month, and in a month the price of Bitcoin was $40,000, would you not ‘ suffer a $10,000 dollar loss. In this case, you exercise your right not to honor the contract, but you will still suffer the loss of paying the premium to buy the contract. Options are also mostly exercised, emphasizing profits.

Perpetual Futures

Perpetual futures are a type of derivative that is extremely popular among day traders. It is the most prolific in crypto, with the traditional financial equivalent being Contracts for Difference (CFD). Unlike options and futures, perpetual swaps do not have an expiration date. You can hold the positions for as long as you like, but you will be charged regular fees to hold your position, called the funding rate.

Given the constantly changing price of the underlying asset, there can be a massive difference between the value of the index price and the price of perpetual futures. So if the perpetual contract price was higher than the index, the longs would pay funding rate fees to cover the difference. The same if the perpetual futures prices were below the index price, the shorts would pay the funding rate fees to cover the difference.

Reasons to use crypto derivatives

Although there are several crypto exchanges that offer spot price assets, you may wonder why some traders opt for derivatives. Some of the reasons to use derivatives include;

Derivatives were used by farmers to help cushion market price fluctuations. Given the seasonality of farming, there is always the possibility that farmers may experience low yields at some point. However, with the derivatives, the farmers are assured of a given price for their products whenever they are ready.

The same logic applies to the crypto world. Given the volatile nature of cryptocurrencies, you are never certain of future values. This can be detrimental if you depend on crypto for your income. For example, crypto miners always want to ensure that they get the best prices. Without an assured future value, it makes it difficult for them to budget and project future profits. Derivatives such as futures (not perpetual futures) ensure that miners can project their income regardless of market movement.

Crypto derivatives support speculation in several ways. The main reason why it is so popular among day traders is because of the use of leverage. Most crypto derivatives exchanges allow traders to open positions larger than their deposits within a given ratio. The leverage increases the possible winning margins, at the same time it comes with the risk of higher losses, such as losing your entire account balance if the trade goes south.

Derivatives in DeFi

All growing markets at some point develop a derivative market that can grow larger than the underlying market. In the last few years, decentralized finance (DeFi) has been on an upward trend. Like any other financial setup, it also has a corresponding derivative market.

The crypto community is excited about DeFi derivatives due to their decentralized nature. Unlike traditional finance, anyone can use DeFi in a permissionless and open way. This opens up the market for more creativity.

Some of the top DeFi derivative platforms right now include;

Synthetics

Synthetix is ​​the most popular protocol among the derivatives in DeFi. It allows the creation of synthetic assets that track the value of underlying assets such as fiat currencies, commodities and cryptocurrencies.

Synthetix works on a debt model so the trader gives collateral in the form of SNX tokens to issue an asset. The system is already over guaranteed by around 500%. Therefore, for every $50 of SNX tokens given as collateral, a trader can only get $10 of the synthetic assets.

ONE

UMA is also a protocol that supports the creation of synthetic assets. However, unlike Synthetix, it is not highly guaranteed. Instead, it relies on liquidators who search for highly collateralized positions and then liquidate them for incentives.

Open up

Launched in 2020, Opyn is a DeFi project that allows trading ETH downside and upside. It also provides protection against ETH volatility, flash crashes and other price movements.

The project also launched a second version that comes with European, cash-settled options. This option automatically confirms at maturity. Once a trader has taken a position, they do not need to do anything else.

Frequently Asked Questions About Crypto Derivatives

How big is the market for crypto derivatives?

The market for crypto derivatives is huge, has exploded in the past few years. A recent study determined that the market can trade over $100 billion on any given day. This is greater than the daily trading limits at the New York Stock Exchange.

The daily trading in derivatives market exceeds that of the crypto market by more than five times.

Do crypto derivatives affect the value of cryptos?

Yes, studies have established that crypto derivatives have an impact on crypto values. The value of crypto comes from the market dynamics of supply and demand. As the derivatives of the underlying asset become popular, it increases credibility, hence better valuations.