Key takeaways- Derivative markets for cryptocurrency involve contracts between a buyer and a seller to trade an asset at a pre-agreed price on a specific date. This gives traders the ability to profit between the contract and the underlying market price difference.
- Advanced crypto trading strategies regularly use futures, options and perpetual contracts to take advantage of leverage and depressed markets and to hedge risk against spot trades.
- Futures contracts obligate a buyer and seller to trade at contract expiry, while options contracts only give the option to buy. Perpetuals are similar to futures but have no explicit expiry date.
- Volatility in crypto derivatives can be taken advantage of to speculate on future price movements while enjoying low fees and avoiding the burden of direct asset ownership.
Cryptocurrency trading has become highly sophisticated over the last decade. Many of the leading exchanges have introduced complex financial products inspired by traditional finance.
Crypto derivatives are now commonplace in the market.
Often, exchanges list them for trading before the underlying asset. Plus, there are dedicated derivatives platforms where you can’t even trade the actual crypto coins and tokens.
If you’re new to derivative trading, then keep reading this simple crypto derivatives 101 guide. By the end, you’ll have a clear understanding of futures, options and perpetuals in crypto and how they work.
What are crypto derivativesDerivatives are a financial contract between two traders: one buyer and one seller. The contracts either oblige or offer the option to trade an asset at a predetermined price on a specific date.
Let’s understand the concept via a simplified example:Two parties agree to trade one Bitcoin for $70,000 on Nov. 30, 2024. On this expiry date, the buyer must buy, and the seller must sell at this price. It doesn’t matter what the price of Bitcoin is trading for on the spot market.
The difference between the contract price and the actual price is where the profit and loss is made. These contracts can be bought and sold during their lifetime for traders to try and profit or reduce risk.
There are numerous types of crypto derivative contracts, but they generally have the same main components:
- Underlying asset: This is the cryptocurrency on which the contract is based. It is the crypto that is agreed upon to be bought or sold at the predetermined price. This could be any crypto from Ethereum to Solana to Dogecoin.
- Quantity: The amount of the underlying asset that will be traded as per the contract. It could be one unit,100 or thousands of a particular crypto.
- Settlement date: The predetermined date on which the contract will be exercised and the underlying asset is bought and sold.
- Method of delivery: This is how the trade is paid out. It could be a trade of the underlying asset or cash-settled equivalent where the contracts are executed using fiat currencies or stablecoins. Cash settlement is most common with crypto derivatives trading rather than trading the actual underlying asset.
How crypto derivatives work: Futures, options and perpetualAs you can imagine, derivatives and their different types can get complicated.Still, in many ways, they are simple and allow investors to bet and speculate on the future prices of a cryptocurrency.
Let’s take a look at the main types of derivatives, their terminology, and how they work.