What is a crypto derivative? 4 types of derivatives explained

Due to their many possibilities, crypto derivatives have gained popularity in recent years among individual and institutional traders. They have many potential benefits as well as some risks. Understanding what they are and how they work is a good step toward determining if they’re right for you.

What are crypto-derivatives?

Derivatives are contracts whose value depends on the value of other underlying assets. Thus, crypto derivatives derive their value from an underlying crypto asset. In the derivatives market, traders use their holdings, speculate on the price direction of crypto-underlying assets and hedge their positions.

The derivatives market allows you to either buy a crypto asset at a lower price and resell it at a higher price in the future, or sell it at a higher price and buy it back later making a profit . If, for example, the price of bitcoin is $15,000 and you think the price of BTC will reach $25,000, derivative contracts allow you to open a long position or buy and hold it until the price of BTC reaches $25,000 dollars.

Conversely, if you think the price will fall from $15,000 to $12,000, you can open a sell or short position and close the contract when the price reaches $12,000; this way you will also close the trade to guarantee a profit even if the price of BTC has fallen.

In both of these examples, the trades would be closed at a loss if both contracts moved in the opposite direction of your speculation.

The derivatives market has been used as a hedge against price volatility and has received increased attention in the increasingly volatile cryptocurrency market. They are traded online on many cryptocurrency exchanges and also over the counter (OTC).

4 types of cryptocurrency derivatives

In this section, we will describe four of the most popular types of derivatives.

1. Futures

A futures contract is an agreement between two parties to buy or sell an asset at a fixed price on a specified date.

Parties can agree to buy or sell crypto in a month, regardless of the current price. After one month, the buyer will make a profit if the crypto price rises and is higher than the agreed price. If the price of the crypto instead falls and stays below the agreed price, the seller will make a profit.

2. Future permanent

A perpetual futures contract is simply a futures contract with no expiration date. This means that investors can hold their positions for as long as they want.

3. Options

Like futures, options also allow traders to buy and sell crypto-assets at a specific price at a future date. The main difference between futures and options is that options give buyers the right, but not the obligation, to buy the underlying value of an asset.

Options contracts are classified into two types: call options and put options. A call option gives the right to buy assets while a put option gives the right to enter into a sale agreement at a specific price and time period.

4. Forward

Forwards are privately negotiated contracts between buyers and sellers to exchange an asset at a specified price at a future date. They are also similar to futures, except that futures are traded on over-the-counter exchanges. Futures contracts are exposed to more risk due to the lack of decentralization.

Differences between derivatives and the spot market

A spot market allows you to buy and sell crypto at will, with the limitation that you can only profit when the price of the asset rises. If the price starts to fall, you will start losing your profit. Spot traders find prolonged periods of bear markets painful, as it is difficult to profit during such times. Another key feature of the spot market is that you can also hold the actual asset you are buying.

On the other hand, derivatives allow you to trade contracts that track the price of an underlying crypto asset, say bitcoin, without owning it. The price of derivatives is set at a level very close to that of the spot market. This market allows you to profit if the price goes up or down.

Derivatives markets can be efficient markets during the crypto winter. However, it takes more time to master derivatives trading. Furthermore, the risks associated with trading derivatives are generally higher than those in the money market.

Benefits of trading crypto derivatives

The ability to use leverage in your account is one of the main advantages of derivatives trading. You can trade derivatives with little capital and expect to make a lot of profit as you have increased your buying or selling power with borrowed money, which is leverage. This advantage also makes it easier for people with low trading capital to trade derivatives.

As the cryptocurrency market becomes more and more popular, many people are looking for ways to exploit its high price volatility to earn more profits as they can profit regardless of the direction of the market if they are in the right position. Thus, derivatives serve as a speculative market to mitigate risk, especially during large price swings.

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The derivatives market allows you to enter the cryptocurrency market without owning any. It also allows for easy diversification, as you can benefit from the price movements of different asset classes without owning any of them.

Disadvantages of Cryptocurrency Derivatives Trading.

Derivatives use speculative tools and price movements can be very unpredictable. Thus, making irrational decisions can lead to significant losses.

Derivatives traders are susceptible to short-term manipulation of crypto market prices. Many of their trades are short-term and since most market manipulations affect short-term market movements, it can affect their positions. The situation worsens when positions are exploited.

OTC derivatives, such as futures contracts, present higher counterparty risk. One of the parties involved may not honor the agreement as contracts are usually privately negotiated and not regulated.

Is Crypto Derivatives Trading Right For You?

Below are some questions to answer to determine if crypto derivatives trading is a good option for you.

1. Are you comfortable with the risk involved?

The derivatives market is suitable for traders with high risk appetite. Traders with a low risk threshold may not be comfortable with derivatives.

You need to understand the factors that cause price changes in the cryptocurrency market. Each financial market has unique factors that cause price changes and affect movement. Likewise, each market also has a unique movement pattern, popularly known as price action. Understanding how they work helps you easily speculate on price direction.

Trading in the derivatives market is much more complex than in the spot market. You should have a good understanding of technical analysis to analyze price action, fundamental analysis to predict the long-term price outlook of a cryptocurrency project, and sentimental analysis to know what the overall mood of the market is and how it might affect it. in shop.

Manage risk

Derivatives trading is suitable for both new and experienced traders. You can choose any of the available options depending on what you prefer and understand best. Derivatives trading, like all other types of trading, is risky; you should always take steps to manage your operations and make only informed decisions.

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