Cryptocurrency derivatives are a new class of digital financial products. Based on financial instruments found in traditional capital markets, cryptocurrency derivatives give traders new ways to capitalize on digital market movements.
Before jumping into the exciting world of cryptocurrency futures and options markets, it’s important to understand what they are, how they work, and the risks associated with them.
What are Cryptocurrency Derivatives?
Derivatives are securities or financial contracts whose value is determined by underlying assets. These assets can be commodities, currencies, stocks or bonds. With derivatives, investors trade these financial instruments rather than holding or owning the asset itself.
Cryptocurrency derivatives perform similar functions to their counterparts in traditional markets, only do so in the digital asset space. Traders use these products to capitalize on cryptocurrency market movements without owning the currencies themselves. Today, many exchanges offer cryptocurrency futures, options, and perpetual contracts.
A cryptocurrency futures is a financial contract in which two parties agree to purchase or sell a specific cryptocurrency at a given price at a specific expiration date in the future. Most cryptocurrency exchanges offer futures products spanning different durations: weekly, bi-weekly, quarterly, or bi-annually.
Cryptocurrency options are futures contracts that give traders the option to settle a contract on expiration at a predetermined price, called the “strike price.” Traders choose between either buying and selling a “call” option or buying and selling a “put” option.
A call option gives the trader the ability, but not an obligation, to buy an asset at a set price for a set date range.
Likewise, a put option gives the trader the ability, but not an obligation, to sell an asset at a set price during a determined date range.
Traders evaluate an options contract by its four key components:
- The underlying asset: The digital or traditional asset that the option contract is based on
- The strike price: The price at which the asset can be bought or sold by the trader
- The expiration date: The date on the option contract expires
- The premium: The price of the option contract itself
Options contracts can be used for a variety of purposes, like hedging or speculative trading. When used correctly, they can help traders minimize their risk while maximizing their potential profits.
Crypto Perpetual Futures
Perpetual contracts are futures contracts with no expiration dates. Instead of closing and reopening positions at set intervals, traders maintain a minimum balance, called a “maintenance margin,” to keep their position open.
Over the course of a perpetual contract, discrepancies between spot and futures prices routinely develop. To ensure that these prices maintain parity, exchanges employ a mechanism called a “funding rate.”
The funding rate is a periodic payment made by either the long and short position holders based on price changes. This keeps the price of the contract close in line with the spot price, while still allowing traders to profit from market movements in their favor.
A negative funding rate happens when index price, such as the spot Ethereum (ETH) price, is higher than the perpetual contract’s price. This means that people shorting will have to pay people who are longing.
Conversely, when the funding rate is positive, the index price is lower than the perpetual contract’s price, meaning that people longing will have to pay those who are shorting.
Perpetual contracts are popular with traders because they allow for leveraged trading and flexible trading strategies such as hedging and provide the opportunity to magnify and protect their profits from both rising and falling markets.
Crypto Derivatives Markets vs. Crypto Spot Markets
Crypto derivatives and spot markets both have their own unique traits:
How to Trade Cryptocurrency Derivatives
Crypto derivatives can be used for hedging and speculation.
Hedging can protect a portfolio from adverse price movements and mitigate potential losses. In hedging, traders open positions that negatively correlate or are contrary to their existing positions.
This position enables you to earn profits even in a bear market, instead of waiting for prices to recover or opting to liquidate holdings at unfavorable prices.
With cryptocurrency derivatives, you can also speculate on the price of cryptocurrencies and potentially earn profits from both bullish and bearish markets.
If you speculate that the market will go down, you can hold short positions on futures contracts. If you speculate that the market will be bullish, you go long on futures contracts. With leverage as high as 20x on FTX, you can earn significant profits even with little price changes in the direction you have bet on.
Popular Cryptocurrency Derivative Exchange
FTX is among the world’s top cryptocurrency exchanges, with a 24-hour volume worth billions of dollars.
Here are the top cryptocurrency derivatives offered by FTX:
FTX Perpetual Crypto Futures Market, Source: FTX.com
Getting Familiar With Crypto Derivatives
Crypto derivatives can make a great addition to investment portfolios. Traders who have a larger appetite for risk unlock a world of opportunities for earning profits. However, traders must first familiarize themselves with the different choices available to them and analyze the opportunities and risks involved before trading.
FTT DAO likes FTX’s derivative products because of ultra low fees, its deep liquidity, broad selection of markets, and a well designed trading engine to ensure proper closing and liquidation of derivative positions to prevent unnecessary losses, in addition to a backstop insurance fund.
Additionally, with each trade on FTX, a percentage of the trading fee is contributed to investments in humanitarian-focused projects as part of FTX’s commitment to effective altruism.
To learn more and support the initiative, join the FTT DAO, a like-minded community of FTX fans promoting effective altruism around the world.