Cryptocurrency/ crypto derivatives are gaining immense popularity across the global crypto markets, providing advanced traders with the capability to implement various trading strategies.
Crypto derivatives have become an increasingly large part of the global crypto asset markets, enabling traders to speculate on price movement or hedge their market exposure.
Read on to learn what crypto derivatives are, what types there are, and how they work.
A cryptocurrency derivatives contract is a tradable instrument tied to crypto value. It lets traders bet on price moves without owning it.
Like traditional derivatives, parties agree on terms: validity, price, quantity.
Crypto derivatives help traders use leverage and hedge portfolios.
For instance, a Bitcoin miner may sell futures to hedge against price drops.
Types of Crypto Derivatives
There are three main types of derivatives contracts in the crypto markets: futures, options, and perpetual swaps.
Futures
Futures are financial derivatives contracts where you have the obligation to buy or sell the underlying asset at a predetermined date at an agreed price in the future.
Cryptocurrency futures enable you to go long or short a crypto asset using leverage, allowing you to speculate on future price developments or hedge market exposure.
Options
Options represent derivative contracts granting the holder the right, though not the obligation, to buy or sell an underlying asset at a predetermined price on a specified future date.
While the option buyer possesses the right, the option seller is bound to fulfill their contractual duty if the option holder decides to proceed.
In a manner akin to futures, cryptocurrency options provide a means to speculate on price shifts or safeguard against exposure to digital asset market fluctuations.
A pivotal distinction lies in the enhanced flexibility of options compared to futures. The absence of an obligation to exercise the option distinguishes options, allowing holders to refrain from execution if the option remains “out of the money.” In such cases, the sole loss incurred is the premium paid for the option.
Read more: How to leverage trade crypto
Perpetual Swaps
Perpetual swap contracts let you speculate on crypto price movements with leverage. Unlike traditional futures, they have no expiration dates.
A funding rate in perpetual swaps aligns the contract price with the underlying asset’s. The difference between the contract and spot prices determines the funding rate.
This structure balances demand for long and short positions. For instance, if a swap’s price is above the asset’s spot price, long positions pay the funding rate to short position traders.
The funding rate system anchors the swap to its underlying asset, ensuring stability.
Pros & Cons of Crypto Derivatives
Now let’s look at the benefits and drawbacks of cryptocurrency derivatives.
Pros
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Leverage: Derivatives allow traders to enter larger positions than their capital would allow in the spot market.
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Risk Mitigation: Crypto derivatives can be used to hedge digital asset market exposure, thus reducing market risk.
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Ability to execute complex trading strategies: Cryptocurrency derivatives allow traders to deploy advancing trading strategies, such as betting on the volatility of the price of a crypto asset.
Cons
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Leverage: Crypto derivatives traders can amplify potential profits with leverage, but it also increases the risk of amplified losses. Given the volatile nature of cryptocurrencies, losses can be significant if not adequately hedged.
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Regulatory: Cryptocurrencies’ legal framework is inconsistent across jurisdictions and can present certain compliance and regulatory risks.
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Counterparty Risks: In the over-the-counter (OTC) derivative market, traders face default credit risk. The due diligence and transaction security exchanges offer isn’t available for OTC derivatives trade.
The global crypto markets are maturing, and the digital asset derivatives market is growing. Perpetual swaps are gaining popularity among crypto traders. Futures and options markets are also growing, indicating demand for derivative contracts in the emerging digital asset class.