When it comes to trading, people usually refer to spot markets where you can buy, sell, and exchange assets. However, there is much more to this — there are other financial tools that allow you to profit from crypto assets without buying them.
Many find it exciting to profit from the volatility of Bitcoin on a daily and weekly basis, but this track doesn’t cater to everyone. A simple asset allocation and HODLing doesn’t offer enough flexibility — no one ever knows for sure where the price goes, and the risk of losing funds is too high.
Crypto derivatives help you protect your funds from unfavorable market movements. Let’s see what they are and how they can help you profit.
Crypto Derivatives — What Are They?
Crypto derivatives are financial tools whose value is derived from certain crypto assets. Say, the price of a Bitcoin derivative is based on the price of BTC. Derivatives had been invented long before cryptocurrency emerged, and they are widely used in traditional financial markets where their value is derived from stocks, bonds, and commodities.
Crypto derivatives are gaining momentum as they allow users to profit from market volatility irrespective of the market direction. This ensures more flexibility compared to holding.
A crypto derivative is a contract between two parties, a buyer and a seller, who agree to buy or sell Bitcoin on a specific day in the future for a fixed price. Parties sign the contract based on their assumptions about the further value movements, and the one who ultimately gets it right, receives the price difference from the counterparty. There are two main types of derivatives: an obligation or option to buy or sell an asset.
Crypto Derivatives vs. Spot Trading
How are crypto derivatives different from traditional markets? With derivatives, you don’t have to choose a wallet to keep your funds and bother with security of storage. You don’t have to buy these coins at all.
Spot markets are completely the opposite. When you buy a coin, the only way to profit from it is to buy it at a lower price and sell it at a higher one. If the value of the asset goes down, you lose money. If you bought BTC at $30K and the price soared to $40K, you will make a $10K profit when you withdraw.
With derivatives, you won’t lose money even in a bear market. The instrument allows you to go short on Bitcoin and profit from the downtrend. If you feel that the asset will appreciate, you can go long.
What Types Of Crypto Derivatives Are There?
There are futures, options, and perpetual contracts.
Futures obligate two parties to buy or sell a crypto asset for a fixed price on a pre-set time in the future. This contract is obligatory and it will be executed when the time comes. Usually, it’s settled not in cryptocurrency but in the US Dollars.
Let’s give it an example. Imagine that Bitcoin costs $40K today. John expects it to appreciate within 2 weeks, so he opens a long position on his futures contract. His counterpart Sarah believes that in the same period, BTC will depreciate. She decides to short Bitcoin and accepts John’s counteroffer.
In 2 weeks, it’s time to settle. If Bitcoin surged to $45K, Sarah has to pay John the price difference — $5K. If it tumbled to $35K, John has to pay Sarah the same amount.
Options are similar to futures, but they don’t make it obligatory to sell or buy. This type of derivatives simply gives buyers and sellers an option to do so. Fulfilling the contract is not obligatory.
With options, you don’t go long or short. Instead, you can “call” or “put”. Let’s get back to our example with John and Sarah and assume they closed a bi-weekly option $20K contract. After they did so, they have two options of what to do next.
If the Bitcoin price rose by $5K, it makes sense for John to execute a “call” option. As he buys Bitcoin for $40K, he will have a $5K profit if he sells BTC at the market price of $45K right away. Sarah will profit if she takes the “put” option and decides against purchasing Bitcoin. If she “calles”, she loses $5K.
Are options risk-free since you’re not obliged to settle? Not really — you need to pay a fee for entering the contract anyway. For instance, this may be a $1K fee that both parties will be charged. If Sarah doesn’t want to close the contract and pay John $5K, she could just pay the $1K fee and let the contract expire.
In contrast to futures and options, perpetual contracts don’t have an expiry date. A trader can keep them for as long as they want, but there is a condition: a minimum of Bitcoin called a margin should be held.
Another important thing in a perpetual contract is the funding rate. Since the contract cannot expire, its value can considerably change compared to the underlying asset. A group of traders has to pay the funding rate to another group to mitigate this difference.
You can go long or short on crypto assets with perpetual contracts. If John goes long, the contract price can significantly detach from the spot price of Bitcoin. It would make no sense to Sarah to hold her position if not the funding rate.
In this case, we consider a positive funding rate. John and others investors who go long have to pay a fee to Sarah and everyone who went short. This “penalty charge” motivates the parties to close their long positions and go short instead. This change brings the perpetual contract price back to the BTC market price.
The same logic applies to the opposite scenario. If the value of the perpetual contract were lower than the BTC spot price, there would be incentives to go long rather than short.
Why Crypto Derivatives?
Cryptocurrency is volatile, and derivatives protect investors from unfavorable market movements. There are 2 ways to profit from derivatives:
Crypto derivatives can be used to reduce portfolio losses when the market behaves not the way the trader predicted. With hedging, you can go short on an asset (profit from the bear market), and there’s no need to sell your BTC in this case.
You can open a short position with leverage. If it’s 10X, it will cost 1/10 of the price in traditional spot trading. Hedging is the way to protect your funds in the bear market and even profit from the downtrend.
If you have some price prediction skills, speculating derivatives will help you get extra profits. Buying Ethereum or altcoin before the bear market starts is not the best idea. But with a derivative, you may speculate that the price will decrease after you open a short position — and if it goes this way, you will profit if the price goes down.
Where Do I Buy Crypto Derivatives?
You can buy futures, options, and perpetual contracts on crypto exchanges. CoinMarketCap has made a list of top platforms with derivatives’ functionality that have the biggest trading volume. As of April 2022, the Top 5 includes Binance, OKX, Bybit, CoinTiger, and FTX.
Crypto derivatives allow traders to profit irrespective of the market direction — something that is impossible if you buy and hold in a downtrend. If Bitcoin costs $40K and goes down to $35K, you lose $5K. But if you have prediction skills, you can take advantage of the bear market to go short and increase your capital.
Crypto derivatives are convenient as they free you from the necessity to search for secure crypto storage. Not everyone likes to bother themselves with controlling their keys and seed phrases, and derivatives are free from this — they are simply a contract between two parties.
Now that you know the basics of crypto derivatives, do your research to find what type of it fits you most and find a reliable platform where you can sign contracts. The best option here is to use recognized exchanges that have large trading volume and good reputation.