A cryptocurrency derivative is a contract or product whose price is determined by an underlying asset such as commodities, stocks, exchange rates, currencies and interest rates. This mechanism allows buyers and sellers to bet on the future value of the underlying asset in order to make a profit.
This article explores all the basics of cryptocurrency derivatives and derivatives trading so you can be better informed.
Derivatives trading – The rudimentary concept
When trading derivatives, the underlying asset can be any cryptocurrency token in which buyers and sellers enter into a financial contract. This contract is speculating in the price of crypto at a future date.
In its first phase, the contract allows both parties to agree on a sale / purchase price for the crypto token on a specific day. This price is independent of the market price and is not affected by the associated fluctuations.
As a result, investors can benefit from price fluctuations in an underlying in two ways. They can buy cheaper or sell more expensive.
Where to trade derivatives?
You can trade crypto token derivatives on centralized exchanges. In addition, most decentralized exchanges allow this type of trading. These derivatives trading platforms are much more flexible than any spot margin trading that gives you access to different, otherwise unknown markets.
Types of crypto derivatives – most preferred options on the market
Depending on the initial terms of a contract, crypto derivatives may be one of the following types.
• Futures contracts: The futures contract is a legal agreement between buyer and seller. It involves the purchase or sale of an underlying asset at a predetermined price and date in the future.
• Possibility : Options give the trader a choice but remove the responsibility to buy or sell the underlying asset at a certain value at the future date and price.
• perpetual contracts: A perpetual contract, unlike futures or options, has no expiration date or settlement. Under certain circumstances, traders open their positions to trade indefinitely.
• Acts: A swap is a contract to exchange cash flows at a future date under the action of a predetermined formula. These are over-the-counter (OTC) contracts and are not traded on regulated exchanges.
• Extensions: A futures contract is a derivative instrument that uses a non-standard contract to trade the underlying asset at a future time and price.
Significant features of derivatives trading
# 1. Stop / Loss Take Profit:
Stop / Loss take profit is a mechanism that allows traders to specify floor and ceiling values for a given order. As a result, they can automatically leave the market when conditions become profitable.
# 2. Automatic downgrade (ADL):
A crypto exchange’s ADL system automatically delivers an opposing position from a nominated trader when a position cannot be liquidated at a price above the burglary price. ADL also works if the insurance is not sufficient to cover the loss resulting from the contract.
# 3. Partially closing orders:
This feature allows traders to make partial gains by partially closing their orders while continuing to earn consistent profits from the growing market.
Benefits of derivatives
• Reduced transaction fees: In general, derivatives are risk management instruments, and therefore they have lower market transaction costs in contrast to other securities such as spot trading.
• Risk management: The price of the cryptocurrency is related to the contract value. For this reason, traders use these derivatives to mitigate the risks associated with fluctuations in the prices of the underlying assets. In addition, this risk can be transferred to others.
• Effective: The practice of arbitrage in derivative contracts ensures that the market finds its equilibrium when the price of the underlying assets is accurate.
Disadvantages of using derivatives
• Very speculative: There is no denying that derivative contracts work best as speculative instruments. This risky nature makes the process unpredictable, leading to huge losses.
• The risk element is heavy: Although derivatives help mitigate the risk of price fluctuations in the underlying cryptocurrencies, they are undoubtedly very volatile. This happens due to the fluctuating value of crypto tokens after the contract is closed, which costs the trader’s money.
Last thoughts – The future of the derivatives market
According to experts, the market for cryptocurrency derivatives is witnessing an increase in trading volume in the coming years. In the third quarter of 2020, trading volume was around $ 2.7 trillion, an increase of 25.1% over the previous quarter. This huge growth will be evident in 2022 as the market continues to grow and involves traders worldwide.
Also read: Get started in cryptoverse: what you need to know