What Are Crypto Derivatives?
In financial terms, derivatives are instruments that derive their value from an underlying asset. Crypto derivatives therefore derive their value from cryptocurrencies. They exist as financial contracts that two parties enter into to speculate on the underlying cryptocurrency’s price on a future date.
So for example, a Futures contract, which is a type of crypto derivative, will have the parties agree on a selling and buying price of the cryptocurrency in say one month, regardless of what the actual price will be. Fast forward to a month later, the buyer may profit if the price of the underlying cryptocurrency went up and is now higher than the agreed price in the contract.
And if the price of the underlying cryptocurrency goes down and lies below the agreed price, the seller will make a profit because the buyer will be purchasing the asset at a higher price than the actual market price.
What Are The Types of Crypto Derivatives?
Crypto derivatives are of various types and some of these types include:
- Options
- Swaps
- Futures
- Perpetual contracts
These derivatives generally differ depending on the conditions. Let’s start with Futures, what is it?
What are Futures?
As the name suggests, it is a legal agreement between two parties to buy or sell an asset at a set price in the future. So before the parties get into the contract they generally agree on two things. One is the price at which they will exchange the asset in the future and two is the expiration date of the contract which is simply the date the contract will be closed and settled.
How crypto Futures work through a practical example, lets say we have two crypto derivative traders, Mercy and Frank who enter into a futures contract when the price of Bitcoin is $30,000. Mercy is bullish on Bitcoin and she is confident that it will surpass $30,000 in a month which is the expiration date of the contract. This means that she will have to pay the $30,000 for 1BTC regardless of BTC’s price in a month.
Frank on the other hand is bearish on BTC and has his reasons to believe that the price of BTC will drop below $30,000 in the coming month. So the contract from Frank’s perspective, commits him to selling BTC at the agreed price, regardless of the asset’s price in a month.
Alright, let’s look at different scenarios that’ll determine which of the two makes a profit:
- Scenario 1- It could be that Mercy was right and the price of Bitcoin does go up to say, $37,000. So now she’ll actually be purchasing BTC from Frank at a discount. In this case, she’ll make a profit of $7,000 without factoring in fees.
- Scenario 2- Let’s assume Mercy’s prediction was wrong and the price of BTC went down and is now trading at $25,000. She’ll still have to buy the BTC from Frank at the agreed $30000 meaning she makes a $5000 loss while Frank makes a $5000 profit. There are still some nuances to Futures but that is generally how it works.
What Are Perpetual Contracts?
Perpetual contracts are more or less similar to futures but with a distinct difference, they have no expiration date. So investors can hold their positions however long they like. For this reason, perpetual contracts have price pegs to ensure that they are traded at prices that are equal or almost equal to the spot market prices.
This price peg is maintained through a premium called a funding payment that is paid between the contract sellers and buyers to help keep the price in line with the spot market.
Let’s find out how Perpetual contracts work. Say that Mercy decides to invest in perpetual contracts this time when the price of Bitcoin is around $30,000. Since she predicts that the price of Bitcoin may go up, she decides to purchase a perpetual contract at $30,000. After two months, the price of Bitcoin does indeed go up to around $40,000.
So Mercy, who is happy with the $10,000 profit, decides to close her position. Leverage opportunities Another thing about crypto derivatives like Futures and perpetual contracts, is that they offer leverage opportunities.
This simply means that it allows you to open a trading position that is bigger than your trading capital. So in Mercy’s case, if a derivative exchange offers 2x leverage, it means that her capital will now double and so will her profit. However, just as leverage amplifies profits, it also amplifies losses so there is a very high risk of being liquidated.
Let’s quickly see how this may happen in Mercy’s case. But before that, let’s try to break down the following concepts first, that is the initial margin and the maintenance margin. The former describes the minimum value that needs to be paid to open a leveraged position.
For illustration purposes, let’s set this value at $30,000. Meaning Mercy pays an initial margin of $30,000, which will act as her collateral. to open a 2x leveraged position. The maintenance margin, on the other hand, is the minimum amount of collateral Mercy must hold to keep her trading positions open. If Bitcoin’s prices move against Mercy and her margin balance drops below this level, she may be asked to add more funds to her account or be liquidated.
That said, perpetuals are by far the most traded financial instruments in crypto. At the time of making this video, the 24 hour volume of perpetuals was over $126 billion compared to Futures’ $ 5 billion. Though, you might still wonder, why not just hold actual Bitcoin if the price is pegged to it anyway? Well, these derivatives have an important function in crypto of managing risks.
Say Mercy holds actual Bitcoin but its price is going down. Since she is also a crypto derivatives trader, she can decide to purchase a derivative contract whose value swings in the opposite direction of the BTC she holds. Ideally, now she’ll be able to offset the losses of her actual BTC with the gains from the derivatives.
