Cryptocurrency trading has blossomed from a small market to a billion-dollar international industry. Amidst all this, the cryptocurrency derivatives market has gained enough traction. The article highlights all the details you need to know about cryptocurrency derivatives trading.
What are cryptocurrency derivatives?
Mathematics and financial markets walk on similar paths when derivatives come into the picture. The concept of derivatives was introduced in Mathematics. It referred to a value or a variable which has been derived from another variable. Similarly in financial markets, the derivative is an instrument that is derived out of some market products. Its price is dependent on the value of the underlying asset from which it is derived. The underlying asset can range from stocks, currencies, commodities, indices, etc.
When the underlying asset is a cryptocurrency, the derivative is referred to as cryptocurrency derivatives. It is a financial contract between two or more parties based on the future price of the cryptocurrency.
What are forms of derivatives?
Cryptocurrency derivatives trading platforms provide various forms of derivatives for trading. The derivatives can be categorized into the following main types
- FORWARDS – Forward contracts are the agreement between the two parties to buy and sell the crypto asset at a pre-determined time and pre-determined price. Both parties are obliged to respect the agreement.
Ex – Bitcoin Forwards
- FUTURES – Futures contracts are the agreement between two parties to buy and sell the crypto asset at a pre-determined date and pre-determined price. They are just like forwards with the only difference that futures are traded on exchanges and hence are standardized unlike forwards. Forwards give you the option to customize your contract. Since futures are traded over the exchange, it eliminates the counterparty risks which are present while trading forwards.
Ex – Bitcoin Futures
- OPTIONS – Unlike forwards and futures where the buyer is obliged to purchase an asset and seller is obliged to sell an asset, options provide the right to the buyer to choose whether to perform an agreement on a specified date or not. Meanwhile, the seller of the option has the obligation to execute the transaction if the buyer exercises his option. Hence the name “Options”
Ex- Bitcoin/Etherium Options
- SWAPS – A swap is a form of derivative in which one party exchanges or swaps the values or cash flows of one asset (financial instrument) for another. In this cash flow, one value is fixed and the other is variable. The variable value is based on the index price, interest rate or currency exchange rate. Most popularly used swaps are interest rate swaps.
Ex. Bitcoin Perpetual Swap
Why Trade Derivatives?
- VOLATILITY – Cryptocurrency is one of the most volatile financial instruments. This exposes individuals and corporations to huge risks. To protect themselves from the fluctuations in the underlying price of the asset, which is a cryptocurrency, in this case, derivatives come to the rescue. No matter what is the present value of the cryptocurrency, the derivative contract between the parties is tradable at pre-determined price thereby eliminating the volatility risk.
- HEDGING – Hedging is a process that safeguards your finances from a risky situation say adverse price movements. Investors use hedging to limit the loss to a known amount if the underlying asset does lose value. It is similar to taking out insurance for your portfolio. Derivatives can be used to establish a trading strategy in which a loss from one investment is offset by a profit in a comparable derivative.
- SPECULATION – Derivatives can be used to speculate the future price of the cryptocurrency. By doing this, they can achieve profits arising out of the price changes of the underlying cryptocurrency. The trader can book profit from the predicted drop in the value of the cryptocurrency by shorting the coin. Shorting is a trading strategy used wherein the trader is of the view that the value of an asset is going to decrease. In this, you sell the asset before you go forward and purchase it. That means, selling at a higher price and buying at lower thereby leading to profit.
- LEVERAGE VALUE – Leverage is an operating facility provided by the broker or a financial intermediary to an investor which permits him or her to take positions in the market which is larger than the amount of requisite funding. This enables the investor to get greater exposure to the market, investing only a chunk of the total value of the position. In short, it means operating with more currency than is available. Crypto derivatives contracts can be leveraged with up to 100 times value. This helps investors to gain higher returns in comparison to that in the spot market.
Which are crypto derivatives trading platform?
Crypto derivatives can be traded on various platforms
INSTITUTIONAL EXCHANGE – LedgerX was the first federally regulated institutional exchange and clearinghouse that came up with Bitcoin derivatives.
TRADITIONAL EXCHANGE – Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (CBOP) are traditional exchanges that introduced Bitcoin futures. As a matter of fact, CME is the world’s leading derivatives exchange which is handling over 20% of the total derivatives trading volume.
CRYPTOCURRENCY EXCHANGE – Major Cryptocurrency exchanges that offer derivative trading are Bitmex, OKEX, and CryptoFacilities.
UPCOMING EXCHANGE – Nasdaq, the world’s second-largest stock exchange is aiming to enter the derivative space.
From the author
Derivatives can be considered as a boon as well as a bane for the financial markets. Though it was responsible for the global financial crisis of 2007, it is still a major tool in hedging the risk of the portfolio. It is extremely important to be cautious when dealing with derivatives. Make sure to get professional advice before leveraging derivatives.
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