Cryptocurrencies are an emerging asset class with an incredible potential to cause massive disruptions across markets and economies. While traditional financial institutions and governments are skeptical about the role of cryptocurrencies in the global financial arena; Wall Street is gradually coming to terms that crypto is here to stay. It might be irresponsible not to deploy a small fraction of your trading or investment portfolio to cryptocurrencies.
Cryptocurrencies are considered speculative high-risk investment, but their high risk is bundled with potentially high returns that dwarf the performance of legacy assets such as equities, precious metals, commodities or real estate.
What are Cryptocurrency Derivatives?
Cryptocurrency derivatives are trading instruments layered on cryptocurrencies; they derive their value from an underlying cryptocurrency. Derivatives generally provide traders with an opportunity to take advantage of both the bullish and bearish sentiment in the market. Cryptocurrency derivatives include crypto options, crypto futures, and crypto swaps. Derivatives are inherently leveraged; hence, you can expect a multiplier effect on the outcome of derivatives trading.
Cryptocurrency derivatives are broadly divided into Futures and Options.
Cryptocurrency Futures are contractual agreements that give counterparties the right and the obligation to buy (in the Long position) and sell (in the short position) a given amount of a cryptocurrency at a predefined price by an agreed date. Cryptocurrency futures are further subdivided into regular futures and Perpetual Futures. Regular Futures have an expiration date as described while Perpetual Futures run indefinitely without expiring.
Cryptocurrency Options are also contractual agreements, but they only give the holders the right but not the obligation to buy (in the Long Position) and sell (in the short position) predefined units of a cryptocurrency at a given price by a given date. Crypto options always have an expiration date often set three months into the future.
How Do Crypto Derivatives Work?
When trading cryptocurrency derivatives such as Futures or Options, you’ll fundamentally be taking either a Long or a Short position. A Long position is premised on a bullish expectation that the price of the underlying cryptocurrency will increase sometime down the road. A Short position is premised on a bearish expectation that the price of the underlying cryptocurrency will fall in the future.
Let’s say Bitcoin is trading at $10,000 and a trader expects the price of Bitcoin to increase in the short-term, the smart thing would be to buy Bitcoin now. However, a futures contract can give the trader the right to buy a contract for 5 BTC at $10, 000 per BTC for a nominal cost of $5 per BTC for a total of $25 instead of committing $50,000 upfront to buy 5BTC.
If the trader is right and the price of BTC increases, to $11,000 after one month; the trader could execute the contract to purchase 5BTC at $10,000 per BTC for $50,000 instead of the prevailing $11,000 market price would have required the trader to spend $55,000.
Conversely, if Bitcoin is trading at $10,000 and a trader expects the price of the coin to decrease in the short-term, the smart thing would be to sell it now. But what if the trader is not quite sure about that bearish outlook, A futures contract can give the trader the right to sell a contract for 5 BTC at $10, 000 per BTC for a nominal cost of $5 per BTC for a total of $25 instead of cashing out prematurely.
If the trader is right and the price of BTC falls $9,000 after one month; the trader could execute the contract to sell the 5BTC at $10,000 per BTC for $50,000 instead of the prevailing $9,000 market price would have earned the trader $45,000. Conversely, if the trade goes the other way and the price of Bitcoin increases, the trader can hold on to their BTC and all they’ll lose is the $25 spent on the futures contract.
The most interesting thing, however, is that crypto derivatives such as Futures and Options do not require traders to hold the actual coins before they can place a trade.
Where Can You Trade Cryptocurrency Derivatives?
Cryptocurrency trading typically happens on cryptocurrency exchanges and some exchanges also offer additional features to trade derivatives. However, you’ll have the best experience with derivatives on exchanges built exclusively for crypto derivatives trading:
ByBit is one of the leading exchanges that provides exclusive access to the trading of crypto derivatives. ByBit offers traders up to 100X leverage on Perpetual Futures and it is developing a suite of crypto derivatives instruments. Beginner crypto derivatives trades will be quite at home on Bybit because it allows you to complete your signup in less than 30 seconds. Secondly, it provides a demo trading account where you can practice derivatives trading with real-time market data on its Testnet. Lastly, the fact that it doesn’t require a minimum deposit before you can start trading also lowers the barrier to entry.
Bitmex is another exchange focused exclusively on the trading of crypto derivatives. It allows you to trade both Future Contracts and Perpetual Contracts and it allows you to access up to 100X leverage on your trades. The fact that Bitmex requires a 0.001BTC minimum deposit requirement, however, makes it unsuitable for beginners looking for low-risk access to the market.
You can read a full comparison between the two here.
The Role of Derivatives in the Overall Crypto Market
In March 2019, a report by Bitwise and Blockchain Transparency Institute submitted that only 5% ($36B) of the $725B trading volume of cryptocurrencies is genuine. Based on the report, analysts at JPMorgan have estimated that derivatives might account for more than 30% of crypto trades based on the aggregate volume of $12 billion on the CME and Cboe in the same period.
The analysts noted “the overstatement of trading volumes by cryptocurrency exchanges, and by implication, the understatement of the importance of listed futures, suggests that market structure has likely changed considerably since the previous spike in Bitcoin prices in end-2017 with a greater influence from institutional investors.”
For retail everyday investors, derivatives may not be significant – you’ll most likely be making a long-term play to purchase coins in the hopes that their value will rise in future with increased mass-market adoption. However, if you are making a sizable investment in the cryptocurrency market and you don’t want to take the long route to dollar-cost averaging, derivatives might be a great way to test the market before committing a significant bulk of your trading capital to the market.
For institutional traders and investors, cryptocurrency derivatives are the first step in the direction of unlocking network effects in the value chain of the cryptocurrency market. Derivatives are typically powered by increased regulatory oversight, transparency, and high liquidity. Hence, derivatives might be the key to bringing in institutional money into the cryptocurrency market.