As cryptocurrency becomes more mainstream, many of the options available to investors of other commodities are becoming possible for crypto investors. One of those options is derivatives trading.
Trading derivatives is a way to participate in the crypto market, but at a level of abstraction beyond simply buying and selling quantities of crypto. There are both risks and rewards to trading crypto derivatives, and it can be a lucrative opportunity for a smart investor.
Before understanding crypto derivatives, it’s necessary to understand what is derivatives in the first place. Derivatives are an investment vehicle that can apply to stocks, fiat currencies, or nearly any other traded commodity.
The basic idea of a derivative is that two parties enter into a contract whose ultimate value is determined by the worth of some underlying item. In a sense, a derivative is a bet between investors as to whether the value of that underlying item will increase or decrease over time.
To give a basic example: Let’s consider shares of Microsoft stock. One party may believe that Microsoft stock will increase over the next three months, and another party may believe it’s going to decrease. Those two parties can create a contract where one of the two will make money if Microsoft shares go up in the next three months, while the other will make money if Microsoft shares fall.
That’s the general idea of a derivative. But there are quite a few details beyond that concept in real-world derivative trading.
Derivatives and the Crypto Market
So how do derivatives apply to crypto? Simply put, the values of crypto tokens are the underlying assets for derivative contracts.
If you want to trade crypto derivatives, you will be attempting to predict the direction a given cryptocurrency will be going over a period of time. Whether you believe a cryptocurrency is going to appreciate or depreciate in value, there’s a derivative you can invest in to match your projection.
Many of the large crypto exchanges are offering crypto derivative trading. As a result, if you can sign up for an exchange and deposit fiat or crypto currency on it, you can trade crypto derivatives.
Main Types of Crypto Derivatives
Here’s a high-level overview of the most popular crypto derivatives currently being traded.
A futures contract represents an agreement that one entity will buy a quantity of crypto from another entity at a specified future date.
With a futures trade, the key to the transaction is noting the price of the asset at the time of the trade, and then the price of the asset at the specified endpoint of the trade. A futures buyer is hoping that the price of the cryptocurrency in question will increase. A futures seller is hoping it will decrease.
Futures trades are immensely popular with large institutional investors, and with anyone trying to analyze and predict the market.
Options are similar to futures, but with an option the trader is not obligated to buy or sell their asset at the end of the specified period.
With an option, the trader will only execute an option in the event that the value of the cryptocurrency has gone according to their prediction. But the option trader pays a premium for the right to hold an option, meaning that not exercising an option does carry a cost.
Crypto Perpetual Contracts
Not all crypto derivatives have predefined end points. Perpetual contracts are similar to futures trades, but without a specified end date. Instead, perpetual contract traders pay a holding fee for as long as they wish to keep their position open, and can close out when they choose.
Advantages to Trading Crypto Derivatives
As someone interested in trading or investing in crypto, why would you want to trade derivatives? As it turns out, trading crypto derivatives has a number of significant advantages when used wisely.
One of the biggest reasons to trade crypto derivatives is as a tool for risk management. Let’s say you’ve made a sizeable purchase of a particular crypto token. If that token increases in value, you’ll make significant money. But if that token falls, you’re liable for a sizeable loss.
Using a futures contract shorting that currency is a way to mitigate your risk in the event that your cryptocurrency loses value. While you’ll lose money on your primary investment in the token, you’ll then make money on the futures contract, offsetting your loss.
Crypto derivatives also allow you to diversify your crypto investment portfolio. If you’re strictly buying crypto, your only option is betting on gains. But derivatives allow you to make complex predictions about various cryptos rising and falling over set periods of time.
Derivative trading also opens up the possibility of arbitrage, a way to potentially exploit small differences in two or more markets to make guaranteed profits. In short, adding derivatives trading to your toolkit gives you opportunities to use the crypto market to your advantage in a number of ways.
The Value of Leverage
The concept of leverage is integral to the value of trading derivatives. Nearly every crypto exchange trading derivatives allows you to make trades where you can increase your returns far beyond the amount of capital you put up.
This lets you make significant gains on small fluctuations in the price of a cryptocurrency, especially in the short term. It’s often not practical to invest the kind of principal necessary to benefit from minor changes in crypto value, but derivatives trading allows you to position yourself to make money well in excess of what you put up.
Trading derivatives is a potentially lucrative way to trade crypto, giving you the ability to more intelligently predict and react to the market under any conditions.
It’s important to note that you don’t want to jump into derivative trading without a little bit of experience – don’t invest more than you’re willing to lose until you understand what is derivatives. Take a few baby steps to understand the fundamentals, then ramp up your investments as you gain experience and confidence.
Once you’ve mastered the concepts of crypto derivatives trading, you’ll have a vastly greater ability to read and react to the market.