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what are crypto derivatives
Educational
September 4, 2020

Crypto Derivatives 101 : Types Of Crypto Derivatives

Shubham GoyalProduct Specialist

Cryptocurrencies have been around for a decade and then some. In all this time, the price of Bitcoin has undergone a phase some might perceive as mood swings that are characteristics of a teenager. Naturally, this made newcomers to cryptocurrencies feel like school children facing new experiences. However, this volatility has often meant profit for the wise and observant.

In 2017, CME launched the Bitcoin futures contracts on its platform. Thus, announcing to the world that crypto derivatives are here to stay for a long time. Shortly after the launch of these futures, trading activity spiked and the price of Bitcoin shot up to $20,000 before crashing back down to $2,000.

Since this infamous tantrum, the crypto market has flourished into an ecosystem comprising around 5,000 coins and tokens. We have come a long way, and down the road, different developments have increased awareness of cryptocurrencies. One such development is the cryptocurrency derivatives – the most common example of which is Bitcoin Futures.

What are Crypto Derivatives and Why do They Matter? 

By definition, derivatives refer to financial instruments (contracts) whose values are derived from an underlying asset (e.g., Bitcoin, gold, even potatoes) and the fact that these assets will retain some of their price value even after some time has passed. 

When someone trades derivatives, they are essentially buying/selling contracts that represent the actual asset. A contract, in turn, means the chance (Options trading) to buy/sell the asset for a predetermined price and predetermined time in the future.

What Types of Crypto Derivatives Are Out There?

There are broadly 5 types of crypto derivatives out there listed as follows:

  • Futures:

Crypto futures is the most dominant crypto derivative as of now. In a futures contract, both the buyer and seller are obligated to buy or sell the underlying asset when the time comes. They do not have the option of backing out.

  • Options:

Just like Futures, in options to the transaction occurs in the future with a predetermined price. However, there is no obligation to go through with the contract if the buyer/seller doesn’t want to. There are two subcategories in Options trading. 

  • Swaps:

As the name suggests, here, the payment of a cryptocurrency is made in another cryptocurrency only. For example, bitcoins are bought by paying the amount in equivalent altcoins (like Ether). 

  • Perpetual:

This is more like a modification that can be applied to other forms of derivatives. Using this, we can have Perpetual Futures, Perpetual Options, or Perpetual Swaps. The advantage of this is that there is no expiry date on the contract. But the buyer has to pay some sort of premium towards booking the asset for a fixed period of time.

  • Forwards:

Forwards is a contract that can be customized to fit the needs of the trader. This is usually conducted on over-the-counter (OTC) exchanges. Risk factors should also be taken into consideration.

You can learn more about Delta crypto derivatives exchange here

A more practical, real-life example

Imagine Zoe has to buy a Halloween costume worth 1 ETH on the day of Halloween. But Halloween is a few months later. Zoe doesn’t want to buy the costume now. Also, Zoe thinks that the price of the costume will increase on Halloween day. So she asks the shopkeeper to enter into a futures contract that she will buy the costume on Halloween day at today’s price. 

The shopkeeper believes that the price of the costume will decrease on Halloween day, since most customers would have already purchased their costumes. So he agrees since he will make more profit this way. But he asks her to pay a non-refundable advance of 0.1 ETH so as to reserve the costume until then. Fast forward to Halloween day, and one of two possible things is going to happen. 

Case 1: price increases to 2 ETH

Now Zoe is happy that she will have to pay only 1 ETH since they had entered a binding contract. Inclusive of the 0.1 ETH advance. So she got a costume worth 2 ETH at 1 ETH. This is known as a Futures contract where the seller/buyer cannot back out even if the seller is facing a loss. 

Case 2: price decreases to 0.5 ETH

If they had a Futures contract, then Zoe has to pay 1 ETH for a costume selling at 0.5 ETH. But if she had entered an options contract, then she could have chosen not to buy the costume. The seller would keep the advance of 0.1 ETH as a non-refundable amount. 

This is the difference between Options contract and a Futures contract. Now, if Zoe wishes to buy the costume next year instead of today, then she can pay another non-refundable 0.1  ETH advance. This is known as a Perpetual Contract. 

Why Trade Crypto Derivatives: The Advantages

Crypto derivatives have certain useful features such as:

  • Protection from Volatility

Even the smallest price movements can end up having a big impact on the bottom line. Derivatives lock in the price of an asset for the trader, for a set period of time.

  • Hedging

Some traders (particularly institutional traders) and investors use crypto derivatives to hedge their positions in other cryptocurrency holdings.

  • Speculations and Leveraging

Investors often use derivatives to bet on future prices of an asset and it is easier to make large speculative plays due to the ability to leverage on their positions.

How To Trade Crypto Derivatives Efficiently

There are 3 primary approaches you can attempt when trading crypto derivatives:

  • Decide which derivative is best (Price speculations)

At any given time, based on the price fluctuation trend, you should choose between an Options or Futures contract. If the market is bullish, then Options is the one to select. If the market is bearish in nature, you should opt with a Futures contract. If you can’t decide or are unsure, it is better to go with a Perpetual Futures contract to be safe. 

  • Don’t hedge more than you can afford to lose

Another method is in which you can borrow certain assets and sell the “borrowed” asset to someone else. You do this in the hope that the price will decrease in the future and you shall buy the same asset at the lowered price. Hence, successfully returning the borrowed asset with no one the wiser. But if the price increases, then you end up paying the difference out of your own pocket. 

  • Select a reliable derivative trading platform 

Selecting a stable, trusted crypto derivatives trading platform is half the battle won. One should look only for those platforms with high trade volume and verified users for enabling easy crypto trading and mitigating fraudulent cases. Since Delta offers rich functionalities and features to its users, it’s an ideal place to start.

Conclusion

In conclusion, crypto derivatives trading is a great option to consider – for both beginners and experts. They can have a significant upside while reducing your exposure as well. Pick the best crypto trading platform, and you’re unlikely to go wrong. To understand crypto derivatives trading in more detail, head over to our next post on types of crypto trades , or check out our dedicated guides on crypto futures or crypto options.

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