As the coronavirus pandemic’s emergence has streamlined digital assets and crypto’s popularity in 2020, mainstream acceptance of the maturing cryptocurrency industry doesn’t seem distant anymore. Derivatives are one of the currently popular directions responsible for this, and must certainly not be ignored.
Generally, crypto derivatives nowadays are a rather speculative instrument, with the only known goal of producing a capital gain or loss requiring very little capital. They’re controversial in the cryptocurrency industry, having regulatory authorities repeatedly point out the risks of price manipulation in crypto markets.
As Bitcoin liquidity is still reasonably low, individual market participants can manipulate the spot price by placing large sell orders. At the same time, they bet on falling crypto prices in the derivatives market through the use of options or futures. Firms that research and analyze blockchain have shown that there is a strong correlation between the monthly expiration of CME futures contracts and a falling Bitcoin price. This was seen as evidence of Bitcoin price manipulation – but could not be proved.
On the other hand, institutional investors also use derivatives for risk management purposes, because futures and options can limit potential losses in crypto trading. Therefore, a broader supply on an established exchange is a positive development.
What is the reason for such a massive surge in crypto derivatives trading during the last few months?
If we compare the bond market and the stock market, we find that the latter allows one to potentially get higher returns at a greater risk. The current economic crisis has meant it is more challenging to find relevant trends that would allow one to get better returns, as most trends clearly correlate with changes due to COVID-19.
While the cryptocurrency market is still volatile, despite a growing maturity, many people simply search for a way to increase their activity with derivative instruments with a goal of higher profitability. Why do they do this? Read on.
Why trade Derivatives?
- Volatility – The volatility of cryptocurrencies 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 the present value of the cryptocurrency is, the derivative contract between the parties executed at a pre-determined price, thereby eliminating volatility risk.
- Hedging – Hedging is a process that safeguards your finances from a risky situation like adverse price movements. Investors use hedging to limit the loss to a precedented amount if the underlying asset does lose value. It’s like 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 similar derivative.
- Speculation – Derivatives can be used to speculate the future price of a cryptocurrency. By doing this, they can attain profits arising out of the price changes of the underlying cryptocurrency. The trader can book profit from the forecasted drop in the value of the cryptocurrency by even shorting the cryptocurrency.
- Leverage value – Leveraging enables the investor to get greater exposure to the market, investing only a chunk of the total value of the position. This helps investors to gain greater returns in comparison to that in the spot market. Leverage play in the derivatives market may be too complicated for mainstream users and if you’re one of them, check out this post.
What then, are the advantages that Cryptocurrency Derivatives offer?
- Derivative contracts serve as risk mitigation for numerous traders during price fluctuations from the underlying asset
- They allow access to otherwise unavailable assets or markets
- The derivative market can generate insights into market movement
- Cryptocurrency derivatives open up more sophisticated trading strategies
- Without holding any crypto, you could gain access to the cryptocurrency market by virtue of derivatives
And what are the challenges that ultimately need to be worked around?
- While derivatives offer long-term risk mitigation, short-term fluctuations can still lead to significant losses
- Derivatives bear an inherent risk on account of their intrinsically sophisticated contract designs that make valuation extremely complicated
- OTC transactions don’t always follow compliance procedures which can prove to be risky for traders
While the advantages of derivatives in the crypto market cannot be ignored, it is essential to exercise caution. The U.S. Securities and Exchange Commission (SEC) has been closely monitoring cryptocurrency exchanges. It is recommended to investigate the various intricacies of crypto futures and other such contracts and get the necessary permissions before trading futures and options in the crypto market.