Trading

Derivatives trading is popular for a reason. Learn which type of derivatives you should trade including futures, swaps, options & more.

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Global financial markets are among some of the most lucrative industries on the planet. While some disagree, it’s hard to ignore how the financial markets thrive with instruments to raise capital, secure supplies at low prices and make credit out of thin air. Derivatives trading is among such fascinating concepts. Unlike spot trading, derivatives trading is more flexible and manageable since it derives its value from a primary underlying asset. And crypto derivatives markets often make use of leverage.

Generally, derivatives trading refers to a mechanism under which traders sign a contract to trade an underlying asset at a specific date and price. The primary intent behind derivatives trading is to speculate on the underlying asset’s future price, allowing traders to book profits based on the price difference

. And it is applicable across various assets, including commodities, currencies, and 

. While the most common form of cryptocurrency derivatives includes the Bitcoin futures. 

As the primary focus of this post is to introduce how traders can use derivatives trading in cryptocurrencies, here’s what we’re going to discuss:

Derivatives trading is a vast financial market. In the simplest form, derivatives trading is an exchange of contracts that binds two parties (buyers and sellers) to sell or purchase an asset at a specific date in the future. The different types of derivatives include futures, forwards, options, and perpetual swaps, and it’s applicable in the crypto context.

To better understand derivatives trading, it is essential to define derivatives first. A derivative is a contract between a seller and a buyer to trade an underlying asset at a specific price. For instance, a Bitcoin futures contract allows traders alike to hedge positions to mitigate price volatility by signing an agreement that settles on an underlying auction price of a Bitcoin. 

Derivatives trading has gained momentum back in the 1970s, making it one of the oldest financial contracts that still exists. However, 

that crypto derivatives trading receives a soaring interest from the public to protect themselves from price fluctuations. For example, the monthly trading volume 

, making it one of the highest-record for crypto derivatives trading.

How Is Derivatives Trading Different from Spot Trading?

As its name suggests, spot trading is a mechanism that involves trading assets at current prices on the spot. The trades settlement are commonly settled within two business days after the transaction date.

When comparing derivatives trading and spot trading side-by-side, here are the differences:

In simple words, spot trading involves fulfilling short-term goals, whereas derivatives trading focuses on long-term prospects.

 are among the most popular types of derivatives. It grants buyers the right to purchase an asset and sellers to sell an asset at a fixed price in the future (agreed upon date). Most traders close their futures contract before the contract expires, booking their profit or loss in the process. Typically, traders would use a futures contract to hedge other investments when trading in a volatile market like crypto.

Take Bitcoin as an example. If a trader believes the price of 1 BTC could fall after crossing $18,000 (at the end of November 2020), the trader will use a futures contract as a hedge to protect his current margins. Assuming the trader purchases a futures contract with one-month maturity, if the prices go below $18,000, the trader would be able to safeguard his profit.

However, in the reverse scenario, the trader will lose on any gains Bitcoin books over the next month.

Forwards are similar types of contracts to futures. However, a forward contract distinguishes itself by over-the-counter trading exchanges rather than a centralized exchange. That means buyers and sellers can customize a buy and sell contract between two parties. Despite the flexibilities, traders need to be aware that the lack of centralization means it’s riskier when trading forwards.

On the other hand, options are derivatives that allow an individual to have the right to buy or sell an underlying asset at a given price at the end of the maturity period. However, there are no obligations attached to options contracts. There are two types of options contracts;

For example, suppose a trader wants to buy 1 BTC at $15,000 per BTC, even the crypto market is volatile, and the price is fluctuating vigorously. The trader then chooses call options to lock in the opportunity of 1 BTC for $15,000 for a specific period. So, when the agreement is expiring, and assuming the Bitcoin price surged from $15,000 to $30,000, the trader will get to buy 1 BTC at $15,000 (predetermined options rate) and gain $15,000 as net profit.

Perpetual swaps are a type of derivatives that resembles futures contracts except it doesn’t have any expiry date or settlement. Traders pay a funding price for perpetual swaps that align the swap’s price with that of the underlying asset. Typically, the 

 tend to mimic the concept of the margin-based spot market. Thus, the trade is close to the underlying reference of Index Price. However, depending on the contract specifications, the agreement can differ from its funding rate, leverage, and more.

Unlike futures contracts, perpetual swaps witness a lower price movement, making them a suitable tool for investors seeking long positions.

The Uses of Derivatives in Crypto Trading

Crypto traders use derivatives for risk management, also known— hedging. Since derivatives are commonly used to speculate future prices in a volatile market, traders usually use them to protect their portfolios against any price fluctuations. For example, a crypto trader would hedge with perpetual swaps that involve betting in the opposite direction to mitigate potential risks of a severe loss, especially from the market dump.

Let’s say you bought 1 BTC in a spot market for $15,000, and you think the price might fall. Instead of selling, you can open a short position with leverage in the perpetual swaps market, so you will profit from the spot trading when the BTC price soars. And when the BTC spot price falls, you minimize losses from the initial position through the short position gains. 

Another common use for derivatives in crypto trading is for price speculation of assets without purchasing the underlying asset. Traders can buy a futures contract instead of buying an actual Bitcoin or altcoins. That means a trader only needs to spend a minimal amount to gain exposure in the market. So, as the price of the underlying asset fluctuates, the trader can adjust his position accordingly. Most traders would use put options to manage their risks.

What Are The Perks to Trade Crypto Derivatives?

The Limitations of Crypto Derivatives Trading

Derivatives trading has its advantages as well as limitations. Some of the prerequisites for derivatives trading are:

Considering these prerequisites for crypto derivatives trading, ideal investors for derivates include:

For investors planning to trade in crypto derivatives, the first step is to register on a crypto exchange or traditional exchange that facilities crypto derivatives trading. Here is a step-by-step process a crypto trader needs to follow.

Ideally, the trader should develop a plan before trading in derivatives. Some exchanges offer lower fees for their native tokens, so it could be wise to use them for cost-efficiency.

Crypto derivatives trading offers several growth prospects to the right trader. The trick is to devise a strategy before starting with crypto derivatives. A trader should analyze and understand the risks associated with derivatives trading before making the first trade.

What Is Crypto Derivatives Trading & How Does It Work?

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