While some may think that derivatives are only for the world of stocks and bonds, players in the crypto markets have now added this revolutionary tool. First off, what exactly is a derivative? A derivative is a financial instrument that has its value derived from another financial instrument. For example, an option on a stock gets its value from the underlying stock. Now that this has been cleared up, I can begin to explain why exactly adding this feature to crypto markets is a big deal.
What derivatives are offered?
It appears that for the moment the main derivatives offered are options and futures, although I am sure that in the future this will change.
The first derivative that somebody should know about is options. The idea of an option is that it gives the holder of it the option and not the obligation to buy or sell the underlying instrument at a predetermined price at a predetermined date. Past this date the option is considered expired and therefore worthless.
There are two main types of options- puts and calls. If you are bullish about the price of something, you buy a call. Let us have an example. Say that I believe coin x has a bright future. It is currently trading at $1 and I buy 1 option contract for it with the strike price at $2. While there is a lot more going on than just this, you want the price of x to get near $2 and you will make off handsomely. The price of this optionality is a premium, and each contract has a different premium determined by many factors. Importantly, you never actually hold any of coin x in a wallet. A put works the opposite way and it is a bearish derivative.
Futures allow you to lock in a selling or buying price for a set date. In commodity markets futures allow both producers and consumers to have more certainty with their prices and reducing the feast and famine aspect of the commodity cycle, but in the world of crypto it is purely for speculation. Say coin y is at 10 dollars, and you buy a future that allows you to sell it for $20 in a year. If the price stays below $20, you are the winner, as you get to sell it above its market value. If it increases above $20, you are the loser and the buyer is the winner, as they get the coin for below the market price and can then immediately sell it for the true price.
This is a crash course in these derivatives markets, and there is a lot more to be learnt.
Why is this a big deal?
The fact that there has been the introduction of derivatives means that sophistication and respectability has been brought to the market. Bigger players (namely investment banks and hedge funds) in their pompous ways believe that without derivatives, the underlying instrument doesn’t exist. Furthermore, if they can make money from selling derivatives, they will certainly have a part in creating it. This is the beauty of capitalism, as even if the bigger players don’t 100% agree with cryptocurrency, they certainly will help in making it mainstream if there is a profit to be made.
How can I use this to make money?
With derivatives, there is a plethora of opportunities to increase your returns. With the volatility seen in cryptocurrency, the most obvious use would be for hedging. This can be done, however, I believe that there is a better way to go. The volatility is something that should be welcomed, not feared. I imagine that if you are reading this you will be most likely bullish. If you buy multiple far out of the money calls that consist of only a small portion of your portfolio, you can catch the benefits of positive black swans. A black swan is something that occurs out of the ordinary and isn’t accounted for in an assets price. Anybody who has followed crypto for even a week knows that there is an immense amount of fluctuations with prices, so there is a large chance of a large payoff.
The future of crypto looks bright, and the implementation of new instruments such as derivatives definitely makes the sector even more exciting for investors.
I am not a financial advisor. This is simply my opinion so do your own research before investing. I can’t be held liable for any losses you occur if you follow the strategy in the article.