Due to its numerous opportunities, crypto derivatives have gained popularity in recent years among individual and institutional traders. It has many potential benefits, as well as some risks. Understanding what they are and how they work is a good step in determining if they are right for you.
What are crypto derivatives?
Derivatives are contracts whose values ​​depend on the value of other underlying assets. Therefore, crypto derivatives derive their values ​​from an underlying crypto asset. In the derivatives market, traders take advantage of their holdings, speculate on the price direction of the underlying crypto assets, and hedge positions.
The derivatives market allows you to buy a crypto asset at a lower price and sell it back at a higher price in the future or sell it at a higher price and buy it back later and still make a profit. If, for example, the price of Bitcoin is $15,000 and you think the price of BTC will rise to $25,000, derivative contracts allow you to open a long or buy position and hold it until the price of BTC reaches $25,000. .
Conversely, if you think the price will drop from $15,000 to $12,000, you can open a sell or short position and close the contract when the price reaches $12,000; That way, you will also close the trade to lock in a profit even though the BTC price has gone down.
For both examples, trades would be closed at a loss if the two contracts were contrary to their speculated direction.
The derivatives market has been used as a hedge against price volatility and has enjoyed increased attention in the ever-volatile cryptocurrency market. They are traded online on many crypto exchanges and also over the counter (OTC).
4 types of crypto derivatives
In this section, we will describe four of the most popular types of derivatives.
1. Futures
A futures contract is an agreement between two parties to buy or sell an asset at a fixed price on a certain date.
The parties can agree to buy or sell cryptocurrencies in a month, regardless of the actual price. After a month, the buyer will benefit if the price of the crypto increases and is higher than the agreed price. If the price of the crypto falls and stays below the agreed price, the seller will make a profit.
2. Perpetual futures
A perpetual futures contract is simply a futures contract with no expiration date. This means that investors can hold their positions for as long as they want.
3. Options
Like futures contracts, options also allow traders to buy and sell crypto assets at a specified price at a future date. The main difference between futures and options is that options give buyers the right but not the obligation to buy the underlying security of an asset.
Option contracts are classified into two types: call options and put options. The call option entitles you to purchase assets, while the put option entitles you to enter into a sale agreement at a specified price and period.
4. Forwards
Forward contracts are privately negotiated contracts between buyers and sellers to trade an asset at a specified price at a future date. They are also similar to futures, except that futures are traded on OTC exchanges. Forward contracts are prone to more risk as there is a lack of decentralization.
Differences between derivatives and spot market
A spot market allows you to buy and sell cryptocurrencies as you wish, with the limitation that you can only profit when the price of the asset rises. If the price starts to fall, you will start to lose your profits. Spot traders find prolonged bear market periods distressing because it is difficult to make a profit at that time. Another important feature of the spot market is that you can also hold the actual asset that you buy.
On the other hand, derivatives allow you to trade contracts that follow the price of an underlying crypto asset, say Bitcoin, without owning it. Derivatives are expected to be priced very similar to the spot market. The market allows you to make a profit regardless of whether the price increases or decreases.
Derivatives markets could be effective markets during the crypto winter. However, more time is required to master how to trade derivatives. Furthermore, the risks involved in trading derivatives are often higher than those of the spot market.
Advantages of trading crypto derivatives
The opportunity to leverage your account is one of the main advantages of trading derivatives. You can trade derivatives with little capital and expect to make a lot of profit since you have increased your buying or selling power with borrowed money, which is leverage. This advantage also makes it easier for those with little trading capital to trade derivatives.
As the crypto market becomes more popular, many people are looking for ways to exploit its high price volatility for more profit, as they can earn regardless of the market direction if they are in the right position. Therefore, derivatives serve as a speculative market to mitigate risk, especially during high price fluctuations.
The derivatives market allows you to access the cryptocurrency market without owning any cryptocurrency. It also allows for easy diversification, as you can benefit from the price movements of different asset classes without owning any.
Disadvantages of trading crypto derivatives
Derivatives use speculative tools and price movement can be very unpredictable. Therefore, making irrational decisions can result in significant losses.
Derivatives traders are susceptible to short-term crypto market price manipulation. Many of your trades are short-term, and since most market manipulations affect short-term market movement, they could affect your positions. It gets worse when positions are leveraged.
Derivatives traded in the over-the-counter market, such as forward contracts, have a higher probability of counterparty risk. One of the parties involved could renege on the agreement as the contracts are generally privately negotiated and unregulated.
Is Crypto Derivatives Trading Right For You?
Here are some questions to answer to determine if trading crypto derivatives is a good fit for you.
1. Are you comfortable with the risk involved?
The derivatives market is suitable for traders with a high appetite for risk. Traders with a low risk threshold may not feel comfortable trading derivatives.
2. Do you understand how the market works?
You need to understand the factors that cause price changes in the crypto market. Each financial market has unique factors that cause price changes and affect movements. Similarly, each market also has a unique movement pattern, popularly known as price action. Understanding how they work helps you easily speculate on the direction of the price.
3. Do you know how to conduct a business analysis?
Trading in the derivatives market is much more complex than in the spot market. You need a good understanding of technical analysis to analyze price actions, fundamental analysis to predict the long-term outlook for the price of a crypto project, and sentimental analysis to know what the general market mood is and how it can affect it.
manage risk
Derivatives trading is suitable for both new and experienced traders. You can choose any of the available options based on the one you prefer and understand best. Derivatives trading, like all other types of trading, is risky; You should always take steps to manage your operations and make only informed business decisions.