As digital currencies become more common as investment assets and means of exchange in financial activities, they continue to upend the economy. One of the products that have shown rapid growth is Crypto derivatives and it is still growing. And, as the bitcoin market expands, so does the diversity of items accessible in the cryptocurrency space.
Derivative markets are significant because their behaviour affects the price dynamics of cryptocurrencies. This article covers the basics of crypto derivatives, what it entails, how it works, its benefits and drawbacks and how to trade derivatives effectively.
What Exactly is Crypto Derivative Trading?
A derivative is, to put it simply, any good or contract whose value is based on an underlying asset. Derivatives are derived from assets such as equities, bonds, interest rates, commodities, fiat currencies, and cryptocurrencies in traditional financial markets, hence the name. Any cryptocurrency token may be used as the underlying asset in crypto derivatives trading.
A financial contract between two parties involves speculation on the price of the cryptocurrency in the future. Regardless of market prices, the parties determine a selling or buying price for the cryptocurrency during the first phase of the contract. As a result, by buying the currency at a lower price and selling it at a higher price, investors can benefit from changes in the price of the underlying asset.
According to the analysis, the market for cryptocurrency futures reached a height of $4.96 trillion in 2021, and in February 2022, 62.7 percent of all cryptocurrency trading took place in derivatives as opposed to spot markets. The largest cryptocurrency futures exchange, Binance, was responsible for almost half, or 47.6%, of total volumes.
Most Widely Used Derivatives in Cryptocurrency
The following types of cryptocurrency derivatives are possible, depending on the terms of a contract.
- Futures: A futures contract is a binding contract between two parties that commits them to buy or sell an underlying asset at a given price and time in the future. Direct execution of the contract takes place on a licensed exchange.
- Options: With trading options, a trader has the option but not the obligation to buy or sell the underlying asset at a specified price and future date.
- Perpetual contracts: Contracts that are perpetual don’t have an expiration or settlement date, unlike futures or options. Occasionally, traders may be able to hold onto their positions indefinitely (for example, if the account has a specific amount of a cryptocurrency, etc.).
- Swaps: A swap is a contract between two parties that calls for the exchange of cash flows based on a pre-established formula at a later time. They are not traded on exchanges and are OTC (over-the-counter) contracts, like forwards.
Features of Derivative Trading
- Auto Deleveraging (ADL): In the event of liquidation, your cryptocurrency exchange’s ADL system will automatically deleverage an opposing position from a designated trader if a position cannot be liquidated at a price that is higher than the bankruptcy price and there is insufficient insurance to cover the contract loss.
- Insurance Funds: These funds protect traders’ capital from automatic deleveraging even if their holdings fall below the maintenance margin threshold.
- Partial Close Orders: By partially closing their orders, traders are able to capture some profits while still taking advantage of the expanding market.
- Stop/Loss Take Profit: When market circumstances are favourable, traders can immediately quit the market by setting the floor and ceiling prices for an order using the take profit feature.
The Most Effective Way to Trade Cryptocurrency Derivatives
There is no one magic technique that guarantees profits when trading cryptocurrency futures. You can, however, adhere to specific procedures to protect your investment as much as you can and make sure you are choosing wisely before investing.
Choosing the appropriate derivative depending on the direction of price fluctuation is necessary to ascertain which derivative is ideal for you. If the market is bullish, for instance, you ought to choose an options contract. Going with a futures contract is the better course of action if the market is bearish. In the event that you are doubtful or the market is acting erratically, you can opt for a perpetual futures contract to be safe regardless of how the market performs.
Also, be careful not to hedge more than you can afford to lose. One tactic used by seasoned traders is to borrow assets and then sell them to someone else. They do this in the anticipation that a future price drop will enable them to purchase the identical assets for a far cheaper cost.
Then, the borrower can repay the lender for the borrowed assets, keeping the proceeds. The merchant will, however, be forced to pay the price difference out of pocket if the price rises. Therefore, it’s wise to always make sure you can afford any losses your activities may cause.
Choosing a trustworthy trading platform for crypto derivatives is an additional crucial factor to take into account. Choose a trading platform that is well-established, has verified users, substantial trade volumes, and fraud detection safety features.
Benefits of Crypto Derivatives Trading
Crypto derivatives are essential to the crypto economy because their functions extend far beyond an individual trader’s investment portfolio. Derivatives are part of any mature financial system and therefore play a crucial role in developing the cryptocurrency industry as a recognized asset class. Here are the benefits:
Low Transaction Costs
Derivative contracts work to lower market transaction costs since they are risk management tools. As a result, the cost of a transaction in derivative trading is lower when compared to other securities like spot trading.
Risk Management
The value of a derivative contract is directly correlated with the price of the underlying cryptocurrency coin or token. Derivatives are therefore used to reduce the risks brought on by changing underlying asset values. For instance, Mr. A might buy a derivative contract whose value fluctuates in the opposite way from the cryptocurrency or token he already owns. Gains from the derivatives will allow him to offset losses in the underlying crypto currency or token.
Market Efficiency
Arbitrage is a key strategy in derivative trading that helps to ensure that the market achieves equilibrium and that the prices of the underlying assets are correct.
Price Determination
The price of an underlying asset is determined by derivative contracts, which are widely utilised in this capacity.
Risk Transfer
Transferring risk is possible thanks to derivatives, which let investors, businesses, and other parties do so.
Drawbacks of Crypto Derivatives Trading
High Risk
Due to the underlying cryptocurrency coins’/tokens’ frequent value fluctuations, derivative contracts are incredibly volatile. As a result, traders run the risk of suffering significant financial losses.
Speculative
As speculative instruments, derivative contracts are commonly used. Speculative investments can occasionally incur huge losses due to the high level of risk they carry and the unpredictable nature of their value swings.
Bottom Line
Trading in cryptocurrency derivatives is a fantastic choice for both new and experienced cryptocurrency investors. Both centralised and decentralised exchange platforms allow for the trading of it. Depending on the amount of risk you feel comfortable with, you can choose from a variety of possibilities. Keep up with the most recent news if trading in cryptocurrency derivatives is something you’re interested in.
