The crypto market is somewhat similar to the stock market. The procedures and protocols for trading and making profits run parallel to the stock market, although we cannot deny its uniqueness in being a digital asset. Investments in cryptocurrencies are, however, more volatile.
As any good trader would, use the old tactic of buying an asset when the price drops and selling it when the price increases. This process has a drawback of missing out on profits you could have gained if you left the position open for longer. There are other ways that help in preventing or overcoming the disadvantages brought by the volatility in the market.
Derivatives are an example. Derivatives are financial products whose value depends on other assets. Hence the name, stemming from the word ‘derived’. They can be contracts or securities that get their value from (crypto) currency, physical commodities, gold, shares, bonds, or other assets.
Derivatives have become popular financial tools with the expansion of the digital market In the crypto market. Crypto derivatives are traded on exchanges and among customers, although there are different ways for them to be regulated and traded.
Before we dwell on the types of derivatives, a few important things any trader must know are the use of derivatives and their importance.
Use of Derivatives in Crypto Trading
Derivatives are mostly used to speculate on future market fluctuations in the volatile market. In the crypto market, derivatives are used to get benefits from fluctuations in the price of the cryptocurrencies.
An increasing number of crypto exchanges allow traders to trade in derivatives and contracts, although this is currently limited to a few altcoins and Bitcoin. It, therefore, becomes important to determine the best crypto exchange for you before you begin trading crypto derivatives.
You could wonder why crypto derivatives are being highlighted. As per analysts and experts, derivatives will continue to gain popularity as more trading options between cryptocurrencies and fiat are offered to traders. This will lead to an increase in the number of platforms providing options and futures trading.
Market competition is undoubtedly getting fierce, and high-profile exchanges are announcing collaborations and services for crypto derivatives on their platforms. Professional traders are opting to trade in derivatives both short-term and long-term.
The trading volume is on a steady increase, implying that the crypto market is ready to accept derivatives. Newcomers might feel overwhelmed with the complexities involved. But exchanges are finding ways to simplify the derivatives market and make it more client-friendly, safe, and secure.
Types of Crypto Derivatives
Derivatives are usually divided into the following categories:
Futures are essentially contract agreements for the sale or purchase of a cryptocurrency on a future date at a pre-decided price. Here, the buyer or seller is obligated to purchase or sell the underlying asset at the set price, not depending on the current market price at the expiration date. Futures can not be customized though. It has a set of standard rules or terms.
Crypto futures are used as a way of locking profits while trading in volatile markets. Usually, the prices for futures are based on aggregated indices representing each cryptocurrency from a variety of exchanges. In this way, the pricing is always clear and transparent.
These contracts are essentially clones of crypto futures contracts. The difference is that these contracts do not expire, while futures do. As long as they have funds, the traders can hold the position. These are better than futures contracts as the latter requires the traders to invest after every few hours in order to keep their position.
Forwards are like futures, with a major advantage. They can be customized, unlike futures. However, traders have to take note that forwards are generally traded OTC (over the counter). Which means that the trading is processed through a dealer network as opposed to on a centralized exchange. Companies not listed on a formal exchange trade securities through this process. Thus, the associated risks have to be calculated and dealt with. These are fairly rare to find in the crypto industry.
Options are similar to futures, wherein traders can buy or sell a specific amount of asset in a pre-decided price on a fixed date. The difference, however, is that options do not pose an obligation. They just give the owner the right to buy or sell the asset on the decided date. This means that the investors have the option of buying or selling the predetermined amount of cryptocurrency at a decided price in a specific timeline.
Options are of two types:
- CALL: It gives the right to buy (The price of the asset increases depending on the growth in the cryptocurrency rate)
- PUT: It gives the right to sell (The price increases with the decrease in the rate of the digital coin)
Swap is a more complex version of futures. It is a derivative instrument where counterparties agree to periodically exchange fixed and floating rates over a period of time. The swap contract, explains the payment frequency and dates and specifies other terms of swap. The swap market is one of the largest and most liquid global marketplaces, with many willing participants eager to take either side of a contract
Which Crypto Derivatives Will You Trade?
While the advantages of derivatives in the crypto market cannot be ignored, it is necessary to exercise caution. It is recommended to understand the various intricacies of crypto futures and get the necessary permissions before trading in the futures and options crypto market.