what are crypto derivatives?

Crypto Derivatives Explained: Pros & Cons, Trading Strategies

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Investing in virtual currencies is one of the most lucrative ways to capitalise on the growth of digital currencies, where digital assets fluctuate in a broader range than classic instruments.

However, this higher volatility can be risky at times. Therefore, traders engage in crypto derivatives to hedge against market uncertainty and capitalise on the potential of virtual currencies.

These tools present a quicker and safer way to buy and sell digital assets without the hassle of custodial wallets and ownership processing. Let’s expand on crypto derivatives meaning in more detail and shed light on the different types.

Key Takeaways

  1. Crypto derivatives provide higher liquidity and less risk to benefit from volatile and lucrative digital currencies.
  2. These contracts are more accessible and are easier to execute than spot trading.
  3. Crypto derivatives contracts require two parties to agree on the price, types, and amounts to trade cryptos on a specific date.

Understanding Crypto Derivatives

Derivatives are financial contracts between two traders who agree on the date and price of a financial instrument. Thus, the derivative’s contract value tracks the market price of the underlying asset, whether stocks, bonds, commodities or currencies.

Such contracts in the crypto context refer to contracts to buy and sell virtual currencies on a particular date at an agreed price. When the contract execution date comes, both parties exchange the contract value at the agreed price, regardless of market fluctuations.

The main difference between crypto derivatives and spot trading is in the ownership of the principal. Unlike spot trading, derivative contracts do not transfer the subject asset’s ownership.

explaining crypto derivatives

Types of Derivatives in Crypto

Derivative contracts can be implemented on any market, and the subject instrument can be stocks, bonds, currencies, commodities or cryptos. Crypto derivatives require a contract and two parties who agree on the price and date and exist in three main types: options, futures, and perpetuals.

types of crypto derivatives

Options

In option contracts, traders enjoy more flexibility in making the preferred decision. For example, when the expiration date approaches, the trader has the right to oblige and execute as per the derivative specifications or to deny the contract and not process the trade.

Options derivatives have different types of contracts, such as call and put. The call option allows the trader to buy the underlying assets on the contract execution date, while the put means selling the asset at the agreed-upon date.

derivatives options types

Other types are the American and European options, where traders in the above crypto derivatives examples can sell the subject security before the expiration date in the American option. At the same time, traders must execute exactly on the mentioned date according to the European options.

Futures

Futures contracts are the most common and straightforward type of derivatives in cryptos. Futures derivatives contracts entail both parties agreeing to buy or sell an asset at a specific price, date and amount.

This is a common trading crypto derivatives strategy by institutional investors utilising market knowledge and predictions to estimate future price movements and enter into different derivatives contracts.

When the execution date approaches, both traders must transfer the contract value (not the underlying asset) and conclude the contract with both parties realising gains and losses.

For example, if a trader enters a derivative contract to sell BTC at a future date. If the purchase price of BTC was $50,000 and on the contract expiration date 1 BTC = $60,000, the trader gains $10,000.

Similarly, if the BTC price drops to $35,000, the trader incurs $15,000 in losses.

Perpetuals

These are the most flexible and advanced derivatives without an expiration date. Therefore, traders of perpetual futures contracts can keep the asset or the contract for as long as they want.

However, there are some conditions that investors must consider in holding an asset and its perpetual futures contract price, such as funding rate (holding fees) and a minimum margin.

Why is Crypto Derivatives Trading Important?

Trading derivatives is faster than holding and selling the classic way. In other words, investors do not need to find a crypto exchange, purchase a particular crypto like BTC or ETH, transfer it to their wallet, and then find the best time and opportunity to sell it and make some gains.

Moreover, crypto spot trading requires more operations from their digital or custodial wallet, which can take time and have security risks if the transaction gets infiltrated by hackers and scammers. Thus, crypto derivatives traders use this strategy to benefit from these features.

Higher Market Accessibility

Derivatives provide for increased liquidity because they are faster and easier to trade, which makes crypto assets more available. Liquidity refers to the ease with which market participants can buy and sell instruments. Liquid markets have sufficient tradable assets pending in the order book, with many participants willing to take the other side of the trade.

Therefore, crypto derivatives drive liquidity and contribute to overall market efficiency and stability.

Diversifying Trader’s Portfolio

Trading crypto derivatives can be a portfolio diversification tool, allowing investors to explore different options and variations to BTC trading and find the best crypto investment strategy.

Moreover, crypto derivatives facilitate short selling, where traders can sell a particular digital coin if the market declines without owning the underlying crypto asset. On the other hand, in classic markets, traders must own a specific crypto before selling it to the market.

Mitigating Risks of Crypto Assets

Blockchain currencies are characterised by high volatility and unpredictability. If you own ETH, for example, because its price is rising and you want to sell it later at a higher point, the price may make a turnaround and decline without a prior warning. Therefore, owning and trading digital coins and tokens is associated with risk. 

On the other hand, derivatives are contracts with agreed prices, where traders execute the transaction on the execution on the agreed date away from market fluctuations.

Crypto Derivatives Advantages and Disadvantages

After finding a reliable crypto derivatives platform, it is critical to consider some ups and downs of trading these contracts. Let’s highlight some of the risks and rewards of crypto derivatives trading.

crypto derivatives vs spot trading

Pros

  • Crypto derivatives involve fewer risks because they do not require owning the digital coin and mitigating market volatility.
  • They are easier to manage without owning the asset in a custodial wallet or interacting with the blockchain and DeFi exchanges.
  • Traders use derivatives to hedge their risky market position, especially in instruments like cryptos.
  • Derivatives are associated with high liquidity because their ease and flexibility make them more appealing to investors.
  • If appropriately managed, crypto derivative contracts have lower transactional fees, while spot trading entails gas, brokers, and exchange fees.

Cons

  • Uncalculated strategies can lead to unrealised gains if the predetermined price is lower than the actual market price.
  • OTC derivative transactions are not subject to compliance and identity checks, increasing unauthentic counterparty risks.
  • Regulatory frameworks regarding derivatives contracts are different around the world.

Final Remarks

Crypto derivatives are contracts between two parties agreeing on the price and date of exchanging a specific financial instrument, such as BTC or ETH. These tools offer good liquidity and risk management plans and, therefore, are seen as an attractive solution to engage in crypto trading.

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