Global financial markets are among some of the most lucrative industries on the planet. While some disagree, it’s hard to ignore how the financial markets thrive with instruments to raise capital, secure supplies at low prices and make credit out of thin air. Derivatives trading is among such fascinating concepts. Unlike spot trading, derivatives trading is more flexible and manageable since it derives its value from a primary underlying asset. And crypto derivatives markets often make use of leverage.
Generally, derivatives trading refers to a mechanism under which traders sign a contract to trade an underlying asset at a specific date and price. The primary intent behind derivatives trading is to speculate on the underlying asset’s future price, allowing traders to book profits based on the price difference. And it is applicable across various assets, including commodities, currencies, and cryptocurrencies. While the most common form of cryptocurrency derivatives includes the Bitcoin futures.
As the primary focus of this post is to introduce how traders can use derivatives trading in cryptocurrencies, here’s what we’re going to discuss:
What Is Derivatives Trading?
Derivatives trading is a vast financial market. In the simplest form, derivatives trading is an exchange of contracts that binds two parties (buyers and sellers) to sell or purchase an asset at a specific date in the future. The different types of derivatives include futures, forwards, options, and perpetual swaps, and it’s applicable in the crypto context.
To better understand derivatives trading, it is essential to define derivatives first. A derivative is a contract between a seller and a buyer to trade an underlying asset at a specific price. For instance, a Bitcoin futures contract allows traders alike to hedge positions to mitigate price volatility by signing an agreement that settles on an underlying auction price of a Bitcoin.
Derivatives trading has gained momentum back in the 1970s, making it one of the oldest financial contract that still exists. However, recent news reflects that crypto derivatives trading receives a soaring interest from the public to protect themselves from price fluctuations. For example, the monthly trading volume reached $602 billion in May 2020, making it one of the highest-record for crypto derivatives trading.
How Is Derivatives Trading Different from Spot Trading?
As its name suggests, spot trading is a mechanism that involves trading assets at current prices on the spot. The trades settlement are commonly settled within two business days after the transaction date.
When comparing derivatives trading and spot trading side-by-side, here are the differences:
- Holds of the tangible assets: Comparing Bitcoin spot with the derivatives market, investors own, buy and sell actual Bitcoin. Whereas, Bitcoin derivatives market boasts with the concept where investors enter a contract without actually holding the BTC. The agreement can either be contracts, futures, perpetual swaps, options obtaining the values from a Bitcoin.
- Price of the asset: In spot trading, a trader would purchase or exchange an asset at the ongoing market price. Whereas in derivatives trading, a buyer of a futures contract is obligated to buy and receive the underlying asset from the seller that delivers the asset whenever the futures contract expires. In such conditions, the buyer and sellers must agree to trade the asset at a pre-determined price in the future. But depending on the markets, the price of the underlying asset may fluctuate, profiting either of the two parties bound by the contract (derivatives).
- Settlement period: Most spot trades are settled within two days of the trade’s execution by considering the settlement process. Derivatives trading, on the contrary, involves settlement or trading at a specific time in the future. Most of the crypto derivatives trade practice cryptocurrency or cash settlement upon the expiration date to bring liquidity into the derivatives market. However, futures contracts are commonly settled by the end of a set period where the price is pre-determined at the time of entry.
In simple words, spot trading involves fulfilling short-term goals, whereas derivatives trading focuses on long-term prospects.
The Types of Derivatives Trading
Futures contracts are among the most popular types of derivatives. It grants buyers the right to purchase an asset and sellers to sell an asset at a fixed price in the future (agreed upon date). Most traders close their futures contract before the contract expires, booking their profit or loss in the process. Typically, traders would use a futures contract to hedge other investments when trading in a volatile market like crypto.
Take Bitcoin as an example. If a trader believes the price of 1 BTC could fall after crossing $18,000 (at the end of November 2020), the trader will use a futures contract as a hedge to protect his current margins. Assuming the trader purchases a futures contract with one-month maturity, if the prices go below $18,000, the trader would be able to safeguard his profit.
However, in the reverse scenario, the trader will lose on any gains Bitcoin books over the next month.
Forwards are similar types of contracts to futures. However, a forward contract distinguishes itself by over-the-counter trading exchanges rather than a centralized exchange. That means buyers and sellers can customize a buy and sell contract between two parties. Despite the flexibilities, traders need to be aware that the lack of centralization means it’s riskier when trading forwards.
On the other hand, options are derivatives that allow an individual to have the right to buy or sell an underlying asset at a given price at the end of the maturity period. However, there are no obligations attached to options contracts. There are two types of options contracts;
- A call option: It gives traders and investors the rights to agree on buying an asset at a specific price and period.
- A put option: It provides traders and investors with the rights to agree on selling an asset at a particular price and period.
For example, suppose a trader wants to buy 1 BTC at $15,000 per BTC, even the crypto market is volatile, and the price is fluctuating vigorously. The trader then chooses call options to lock in the opportunity of 1 BTC for $15,000 for a specific period. So, when the agreement is expiring, and assuming the Bitcoin price surged from $15,000 to $30,000, the trader will get to buy 1 BTC at $15,000 (predetermined options rate) and gain $15,000 as net profit.
Perpetual swaps are a type of derivatives that resembles futures contracts except it doesn’t have any expiry date or settlement. Traders pay a funding price for perpetual swaps that align the swap’s price with that of the underlying asset. Typically, the perpetual contracts tend to mimic the concept of the margin-based spot market. Thus, the trade is close to the underlying reference of Index Price. However, depending on the contract specifications, the agreement can differ from its funding rate, leverage, and more.
Unlike futures contracts, perpetual swaps witness a lower price movement, making them a suitable tool for investors seeking long positions.
The Uses of Derivatives in Crypto Trading
Crypto traders use derivatives for risk management, also known— hedging. Since derivatives are commonly used to speculate future prices in a volatile market, traders usually use them to protect their portfolios against any price fluctuations. For example, a crypto trader would hedge with perpetual swaps that involve betting in the opposite direction to mitigate potential risks of a severe loss, especially from the market dump.
Let’s say you bought 1 BTC in a spot market for $15,000, and you think the price might fall. Instead of selling, you can open a short position with leverage in the perpetual swaps market, so you will profit from the spot trading when the BTC price soars. And when the BTC spot price falls, you minimize losses from the initial position through the short position gains.
Speculating Future Price Movement
Another common use for derivatives in crypto trading is for price speculation of assets without purchasing the underlying asset. Traders can buy a futures contract instead of buying an actual Bitcoin or altcoins. That means a trader only needs to spend a minimal amount to gain exposure in the market. So, as the price of the underlying asset fluctuates, the trader can adjust his position accordingly. Most traders would use put options to manage their risks.
What Are The Perks to Trade Crypto Derivatives?
- Higher leverage (margin trading): Derivatives trading requires a trader to put a small portion of the overall trade (10% or even lower). The investor can use leverage to boost his profit margins without investing a considerable amount upfront.
- Low commissions: Derivatives trading is cost-efficient, with lower commission charges or execution fees.
- Volatility protection: Cryptocurrencies are volatile, and derivatives are ideal for reducing these long-term price volatility by signing a contract that settles directly to an underlying price.
- Ideal for hedging: For investors seeking protection of their funds, derivatives offer a suitable risk management tool. By considering two-way hedging, a trader can get over most downside risks.
- Offers diversification: Since derivatives trading considers the prices of the underlying assets upfront, they help investors minimize portfolio risk. Plus, the derivatives market is helpful to generate signals of the market movement.
- High liquidity: Derivatives trading markets are highly in demand. Research indicates that the crypto derivatives daily volumes crossed $600 billion in May 2020, gaining momentum with more interest from institutional investors. With such active movement, it opens up opportunities for traders to apply diverse trading strategies to maximize their profits.
The Limitations of Crypto Derivatives Trading
- High risk in derivatives trading: Since derivatives allow investors to leverage, there is always an increased risk of getting liquidated. For instance, if a trader purchases a Bitcoin futures contract for $20,000 to short the market for 10 BTC using leverage, but the market plunges to $18,000 per BTC, the trader will incur a loss of $20,000 on his position.
- Lack of due diligence in over-the-counter derivatives: In an OTC futures contract or forward contract, there is a counterparty risk involved. The trader has no way to run a due diligence check on the other party. That is because OTC transactions do not always follow compliance procedures.
- Regulatory concerns: Not all the jurisdictions around the world legalize derivatives trading. For two parties involved in a futures contract or forward contract, both must operate in regions where derivatives trading is a legal practice, failing, leading to counterparty risk.
Who Should Trade Crypto Derivatives?
Derivatives trading has its advantages as well as limitations. Some of the prerequisites for derivatives trading are:
- High-risk: Derivatives trading, including crypto derivatives, is only suitable for investors with a high-risk appetite. Investors with limited capital or low-risk tolerance should avoid derivatives trading.
- Access to technical or fundamental analysis: Since derivatives trading relies on margin and the ability to read the markets correctly, the investor should have an impeccable understanding of technical and fundamental analysis. Since crypto markets are notorious for price volatility, market research and awareness should be to the point.
- Understand the cryptocurrency markets: Unlike financial markets, cryptocurrency markets are influenced by additional factors that can alter the market momentum, such as a new, cutting-edge crypto asset. Investors involved in crypto derivatives trading should be aware of the latest projects and the new regulations surrounding the cryptocurrency industry.
Considering these prerequisites for crypto derivatives trading, ideal investors for derivates include:
- Institutional investors: Institutional investors hold the right tools, resources to analyze markets, which puts them in the ideal position to trade in crypto derivatives. They can use leverage to boost profits or limit any downside risk in crypto trading.
- Miners or crypto startups: For miners involved in Bitcoin or altcoin mining, investing in derivatives makes sense. The increasing competitions make mining more challenging than it used to be. By hedging with derivatives like futures, miners can diversify their income source. Plus, it allows them to safeguard their profits in the future. Similarly, blockchain projects or crypto startups holding financial resources in cryptos can use derivatives for risk management.
- Advanced investors: Investors with a fair understanding of the crypto markets, technical and fundamental analysis is suitable for derivatives trading. It is essential to understand the risk involved in derivates before trading.
How to Trade Crypto Derivatives?
For investors planning to trade in crypto derivatives, the first step is to register on a crypto exchange or traditional exchange that facilities crypto derivatives trading. Here is a step-by-step process a crypto trader needs to follow.
- Compare features offered by different crypto exchanges, including margin, settlement period, maker/taker fees, and any applicable withdrawal limits. Choose a crypto exchange that provides the best value for the fees it charges. Remembers reputation is vital too. Bybit is one of the best derivatives crypto trading platforms you should consider.
- Open an account with a crypto exchange, complete KYC, fund the account with fiat or crypto transfers.
- Focus on crypto derivatives that the trader is interested in trading. Understand how margin works and choose a margin rate. New investors should utilize a minimum margin at the beginning.
- Purchase futures contracts through a marginal deposit.
- Hold the futures contracts until the due date. Close the position before the end of the maturity period and book profits or realize losses.
Ideally, the trader should develop a plan before trading in derivatives. Some exchanges offer lower fees for their native tokens, so it could be wise to use them for cost-efficiency.
Crypto derivatives trading offers several growth prospects to the right trader. The trick is to devise a strategy before starting with crypto derivatives. A trader should analyze and understand the risks associated with derivatives trading before making the first trade.