What Are Crypto Derivatives & How Do They Work?

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What Are Crypto Derivatives & How Do They Work?

What Are Crypto Derivatives & How Do They Work?

Summary

  • Derivatives are financial agreements whose value is linked to an asset, spanning from stocks and bonds to commodities and interest rates.

  • There are types of crypto derivatives, which include futures contracts, options contracts, Perpetual contracts, and perpetual swaps.

Table of Contents

Derivatives Explained

Derivatives are financial agreements whose value is tethered to an underlying asset, from stocks and bonds to commodities and interest rates.

These instruments enable investors to forecast and wager on the price shifts of the underlying asset without direct ownership. In simpler terms, derivatives can be likened to the prediction value of a given entity.

Types of Crypto Derivatives

There are several crypto derivatives available:

Futures Contracts

Agreements to buy or sell an asset at a predetermined price on a specified future date.

Traders can speculate on the future price of a cryptocurrency. For instance, a Bitcoin futures contract might allow buying one Bitcoin at a set price on a future date. It’s a way to hedge against price fluctuations or engage in speculative trading.

Options Contracts

Agreements provide the right (but not obligation) to buy or sell an asset at a fixed price on or before a specified date.

Traders can buy call options to benefit from a price rise or put options to profit from a price drop. For instance, with a Bitcoin call option, the holder can buy Bitcoin at a predetermined price if the market exceeds that price on the specified date.

Perpetual Contracts

They are similar to futures contracts, but come without an expiration date.

These contracts track the spot price of the underlying asset, and their value is adjusted periodically.

Traders can go long (betting on a price increase) or short (betting on a decrease) without worrying about contract expiry. Funding rates are used to balance the contract price with the spot price.

Perpetual Swaps

A type of perpetual contract that exchanges cash flows between two different assets.

Traders can gain exposure to an asset without actually owning it. An example would be swapping cash flows between Bitcoin and a fiat currency. Perpetual swaps help in hedging against exchange rate risk.

Derivatives Trading in Crypto

Derivatives trading in crypto involves financial contracts linked to digital assets like Bitcoin or Ethereum.

Rather than owning the actual cryptocurrency, traders engage in contracts predicting its future value movements. These contracts, called derivatives, derive their worth from an underlying crypto asset.

Way of Working

Derivatives, represented by contracts, get their value from crypto prices like Bitcoin, Ethereum, or Litecoin.

Traders use leverage to amplify gains or losses by borrowing funds.

This system allows traders to profit in both rising and falling markets by taking long or short positions in derivative contracts.

Importance of Crypto Derivatives

Crypto derivatives play a crucial role in the digital asset landscape for several compelling reasons:


1. Liquidity Boost


Crypto derivatives make it easier to buy or sell digital assets quickly without causing big price swings.

This increased liquidity allows traders to handle significant assets with only a tiny amount of money, making markets more accessible and less prone to sudden price changes.


2. Risk Mitigation


Crypto markets can be unpredictable, and derivatives help manage unexpected risks.

Traders can use derivatives like futures contracts to protect themselves from potential losses due to volatile price movements. It acts as a safety net for their investments.


3. Portfolio Diversification


Derivatives provide options for traders to spread their investments across different assets.

If someone wants to invest in various cryptocurrencies without holding them all, derivatives like perpetual swaps allow them to reduce risk by diversifying their portfolio.


4. Price Discovery Optimisation


Derivatives help figure out what the market expects and influence future price movements.

If there’s high demand for a cryptocurrency but not enough supply, the price of its futures contract rises. This signals other traders about the market direction, aiding decision-making.

How to Trade Crypto Derivatives?

Getting started with crypto derivatives is easy, here are the steps to follow:

1. Get Started

BitDelta is a multi-asset exchange that offers derivatives trading to its users. To get started with derivatives trading, sign in or sign up to the exchange. Register and Verify your account, and don’t forget to enable two-factor authentication for your security.

2. Deposit Funds

Next, deposit fiat or cryptocurrencies based on your choice to trade with. You can then proceed to choose between the spot and futures wallets.

3. Choose a Derivative Contract

Browse available contracts considering details like asset, contract size, leverage, and expiration date. Examine order book, trading volume, and open interest.

4. Place Your Order
  • Choose between market and limit orders.
  • Set stop-loss or take-profit orders if needed.
  • Utilise advanced order types available on the platform.

5. Monitor and Adjust

Keep an eye on unrealised profit/loss, margin balance, liquidation price, and funding rate. Modify or close positions manually as needed.

Pros and Cons

Advantages

Increased Liquidity

Crypto derivatives make it easier to buy or sell assets quickly without messing up prices.

Traders can trade large amounts with less money and access markets that are usually hard to get into.

Risk Mitigation

Derivatives help protect against unexpected price changes, especially in the volatile crypto market.

Traders can lock in profits or limit losses using contracts, managing their overall risk.

Portfolio Diversification

Derivatives offer more options to invest in different cryptocurrencies without owning them.

Traders can gain exposure to various assets, hedge against risks, and trade without holding the assets.

Optimised Price Discovery

Derivatives reflect what traders expect in the market, helping discover prices better.

Market trends and sentiments become clearer, guiding traders in making informed decisions.

Disadvantages

Aggravated Price Swings

Derivatives can intensify market swings, leading to unpredictable ups and downs.

Excessive trading can cause valuations to shoot up during booms and crash down during busts, creating uncertainty.

Higher Risk Due to Leverage

Leverage, or using borrowed money, can amplify both profits and losses in derivatives.

Misusing leverage can lead to severe losses, and the risk of liquidation increases, closing positions automatically.

Which Cryptocurrencies are Ideal for Derivatives Trading?

In crypto, when choosing the right coins for derivatives trading, three key factors come into play: liquidity, volatility, and popularity.

Liquidity impacts how fast you can buy or sell without affecting prices. More liquidity means less risk of manipulation and faster execution. Check the coin’s trading volume, order book depth, and open interest.

Volatility boosts profits, but it also raises the risk of losses. More volatile coins offer more room for leverage and speculation. Look at standard deviation, implied volatility, and historical volatility.

A popular coin attracts more attention and often has a variety of trading products. It indicates market sentiment and potential. Check market capitalisation, social media activity, and news coverage.

Going by these metrics, the following coins are excellent for derivative trading in crypto:

Bitcoin (BTC): It’s the pioneer, highly liquid, volatile, and widely accepted. It is the base for many derivatives like futures, options, and perpetual contracts.
Platforms like Binance, BitDelta, and Huobi offer Bitcoin derivatives.

Ethereum (ETH): Second-largest crypto with high liquidity and popularity. It serves as the base for various derivatives. Platforms like Binance and BitDelta offer Ethereum derivatives.

Conclusion

Crypto derivatives like futures, options, and perpetual swaps, derive value from crypto assets such as Bitcoin, Ethereum, or Litecoin. Traders leverage these contracts to hedge against price fluctuations or capitalise on rising and falling markets.

Engaging in crypto derivative trading demands a high level of knowledge and experience due to its complexity and associated risks. It is essential to do your research before trading derivatives on any exchange.

Are you looking for the best exchange to trade crypto derivatives today? Sign Up to BitDelta exchange to commence your crypto derivatives trading journey today.

BitDelta is a highly secured cross-asset digital exchange. This exchange offers various assets for trading, from stocks to commodities to crypto. It also includes spot trading, derivatives trading, copy trading, futures trading, and options trading.

Audited by Hacken and safeguarded by FireBlocks, this crypto exchange provides safety for your investments as you trade and invest smoothly within the exchange.

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