Have you ever observed the wild swings of the crypto market and wished you could profit from them, up or down? Or, have you ever wondered how crypto derivatives are the drops of gasoline fuelling this surge and slope? Well, you are just in the right spot!
Crypto derivatives offer a new world of possibilities, allowing you to amplify your gains (or losses) and strategically navigate the ever-shifting crypto market. But before you jump in, let’s build a solid foundation.
This blog is your comprehensive guide to mastering the fundamentals of crypto derivatives trading. We will delve into various derivative types, such as futures and options, and demonstrate the functions of Bitcoin derivatives.
We will also discuss the risks involved because, let’s face it, crypto is a rollercoaster! So, buckle up, crypto cadets, and let’s enjoy this educational ride of derivative trading.
What Is Crypto Derivative Trading?
Crypto derivatives are financial contracts whose value is derived from the performance of an underlying cryptocurrency asset. These contracts include futures, options, swaps, and forwards.
Imagine a financial agreement you make with someone else, but instead of directly buying a Bitcoin, you agree to exchange something based on Bitcoin’s future price. That’s the essence of crypto derivatives – contracts that derive value from cryptocurrencies like Bitcoin or Ethereum.
Multiple parties sign contracts to buy or sell a specific asset at a predetermined price. The contract’s value fluctuates in tandem with changes in the cost of the underlying benchmark.
Types Of Crypto Derivatives Trading
Crypto derivatives come in various forms, each serving different market purposes. Let’s delve into the three primary types: futures trading, options trading, and perpetual swaps.
Perpetual Swaps
Perpetual swaps, or perpetual futures or contracts, are similar to traditional futures contracts but with no expiry date. Instead, these crypto derivatives mimic a spot market with funding rates exchanged periodically between buyers and sellers.
In perpetual swaps, traders can take long (buy) or short (sell) positions without worrying about contract expiration. This perpetual nature offers flexibility, as traders can hold positions for as long as they desire, avoiding the need to roll over contracts or manage expirations.
Perpetual swaps often use a funding mechanism to ensure the contract’s price aligns with the underlying asset’s spot price. If the perpetual contract’s price diverges from the spot price, funding payments are exchanged between long and short positions to bring the contract’s price back in line with the spot market.
Futures Trading
Futures trading involves agreements to buy or sell an asset, like Bitcoin or Ethereum, at a predetermined price on a specified future date. It’s like making a promise to buy or sell crypto at a set price in the future, regardless of the actual market price. For example, if you anticipate Bitcoin’s price will rise, you might buy a futures contract at today’s price to lock in that rate for a future date.
Futures trading offers opportunities for both speculation and risk management. Traders can profit from price movements without owning the underlying asset. However, it’s essential to understand that futures trading carries risks, including potential losses, if the market moves against your position.
Options Trading
Options trading grants the buyer the right, but not the obligation, to buy (call option) or sell (put option) an asset at a predetermined price (strike price) within a specified timeframe (expiration date). This flexibility allows traders to capitalise on price movements without committing to buying or selling the underlying asset outright.
For instance, expect Ethereum’s price to increase. You could purchase a call option, giving you the right to buy Ethereum at a set price before the option expires. If Ethereum’s price rises above the strike price, you can exercise the option and profit from the price difference.
Options trading gives traders leverage and the ability to hedge against potential losses. However, assessing the risks involved is crucial, including the possibility of losing the entire premium paid for the option.
Comparing The Types Of Crypto Derivatives
Let’s now compare the types of crypto derivatives and see how they differ from each other:
Factors | Futures Derivatives | Options Derivatives | Perpetual Swaps |
Risk | Ineffective trading strategies and high leverage can pose a significant risk. | Limited risk. However, traders might encounter losses when they inaccurately forecast market movements. | Depends on the volatility of crypto. It can lead to profit or loss depending on price fluctuation. |
Leverage | Traders can increase gains but also escalate risk. | Accurate prediction of price movements is essential to leverage maximum gains effectively. | Perpetual contracts, akin to futures, enable traders to leverage their positions for potential profit. |
Flexibility | Even individuals who do not hold cryptocurrencies can predict asset price movements and generate profits. | Traders can select strike prices and expiration dates for crypto tokens, enabling them to forecast whether the future movement will be bullish or bearish. | Traders can continuously speculate on the price movement of crypto tokens, but this endeavour carries equal levels of risk. |
Hedging | Utilising hedging strategies can mitigate the impact of market volatility and enhance the diversification of a crypto portfolio. | Implementing crypto options strategically can serve as a valuable tool for hedging, effectively mitigating risk when executed correctly. | Perpetual contracts provide crypto traders with opportunities to hedge against price volatility in the market. |
Understanding Bitcoin Futures
Let’s focus on Bitcoin futures, one of the most popular crypto derivatives. Imagine you and a friend make a deal. You agree to buy one Bitcoin from them in 3 months at a price you both lock in today. That’s a Bitcoin futures contract!
Bitcoin futures require two parties to exchange Bitcoins at a predetermined price on a future date. They are a type of Bitcoin Derivatives in which you don’t own a Bitcoin yourself; rather, you bet on its future price. To understand the concept of crypto futures trading, you can head into this blog.
Functioning Of Bitcoin Futures Derivatives
Understanding Bitcoin derivatives’ functioning: futures contracts are straightforward when illustrated with an example.
Suppose Bitcoin’s current price is $50,000. In this scenario, you can buy or sell a Bitcoin futures contract, depending on your prediction for its future price movement.
Suppose you purchase a Bitcoin futures contract at $50,000, given that you are anticipating an upward trend. Subsequently, two outcomes are plausible:
- If Bitcoin’s price escalates to $70,000 by the contract’s expiry, you’d realise a significant profit of $20,000, demonstrating the potential for substantial gains in Bitcoin futures.
- Conversely, suppose your prediction goes awry, and Bitcoin’s price plunges to $40,000 by contract expiration. In that case, you’d incur a significant loss of $10,000, highlighting the importance of careful consideration and risk management in Bitcoin futures.
If you want to trade in crypto derivatives, read our guide to crypto options trading, which can provide more information.
How Does A Bitcoin Futures Contract End?
While futures traders are commonly thought to be obligated to purchase the contract at expiration, this is not entirely true. There are three choices in terms of a Bitcoin futures contract’s expiration:
Settling a Contract
Settling a Bitcoin futures contract is straightforward. When the contract expires, if neither the buyer nor the seller changes their position, it simply expires and settles.
In this case, the seller must deliver the underlying asset per the agreed-upon settlement method.
Offsetting the Position
Offsetting a position is a widely used strategy in Bitcoin futures trading. It involves traders opening an equal-value position opposite to their current position.
For example, if you hold a Bitcoin futures contract to buy, you would also open a futures contract to sell at the same price. The difference between the initial and offset positions determines the overall profit or loss.
This approach allows you to exit a position without physically delivering the asset, often called liquidation.
Rolling Over a Contract
Investors who wish to maintain their position can choose to roll over their futures contracts.
For example, if you hold a Bitcoin futures contract expiring in three months, you can sell it and purchase a contract with a longer expiry, such as six months.
Rolling over a contract enables you to extend your position while avoiding the need for physical delivery.
How Can You Earn Money Using Bitcoin Futures Trading?
Investors can profit from Bitcoin’s derivative futures by speculating on the direction of Bitcoin’s price movements.
For instance, if you open a long position, you are betting that the price of Bitcoin will increase. To do this, you buy a contract to purchase Bitcoin at its current price, anticipating it will rise.
You hold the contract until its expiration date, and if the price has increased, you can sell it and pocket the difference as a profit.
On the other hand, if you take a short position, you are betting that the price of Bitcoin will fall.
In this case, you sell a contract to sell Bitcoin at its current price, expecting the price to decrease. You hold the contract until the expiration date, and if the price has fallen, you can buy back the contract at a lower price and profit from the difference.
Trading Strategies For Bitcoin Futures
There are multiple strategies available to investors who trade Bitcoin derivatives contracts. Some of the more commonly used strategies include:
Day Trading
Investors actively open and close positions within the same trading day to capitalise on short-term price fluctuations. This strategy involves executing numerous small daily trades to capture incremental price movements.
Swing Trading
Traders seek to profit from medium-term price swings over several days or weeks. Unlike day trading, positions in swing trading are held longer, allowing traders to capitalise on broader market trends.
Trend Following
This strategy involves identifying and following established market trends. Traders go long in bullish markets and short in bearish ones. Technical analysis tools like moving averages are crucial in identifying and confirming trends.
Contrarian Trading
Traders adopt positions contrary to the prevailing market sentiment. They buy when sentiment is overwhelmingly bearish and sell when it becomes excessively bullish. This strategy relies on the assumption that crowded trades may reverse.
Arbitrage
Traders execute risk-free profits by exploiting price differentials between Bitcoin futures and spot markets. Arbitrageurs capitalise on market inefficiencies by simultaneously buying low and selling high across different markets.
Hedging
Investors utilise Bitcoin futures to safeguard their cryptocurrency holdings from adverse price movements. Investors mitigate potential losses from price fluctuations by taking offsetting positions in futures contracts.
Pairs Trading
Simultaneously taking long and short positions on correlated assets, such as Bitcoin and altcoins, traders aim to profit from relative price movements between the two assets. This strategy relies on identifying relationships between assets and capitalising on their divergences.
Breakout Trading
Traders identify critical support and resistance levels and enter positions when Bitcoin’s price breaks through these levels. Breakout traders aim to ride the market’s momentum by capitalising on significant price movements.
Range Trading
Identifying a trading range where Bitcoin’s price fluctuates within defined boundaries, traders buy near support levels and sell near resistance levels. This strategy aims to capitalise on predictable price movements within a specific range.
Algorithmic Trading
Automated trading programs execute trades based on predefined algorithms and criteria. These algorithms analyse market data and execute trades rapidly, allowing for rapid decision-making and execution. Algorithmic trading strategies range from simple rules-based systems to complex machine-learning algorithms.
Advantages Of Crypto Derivatives
Crypto derivatives, whose value is derived from an underlying cryptocurrency asset, offer several advantages to cryptocurrency market traders and investors.
Understanding these benefits is essential for those looking to leverage derivative instruments effectively.
Hedging Against Price Volatility
One key advantage of crypto derivatives is their ability to provide security against price volatility. Investors can use futures contracts or options to safeguard their cryptocurrency holdings from sudden price fluctuations.
For instance, a Bitcoin miner may use futures contracts to lock in a future selling price, ensuring they can cover operational costs even if Bitcoin’s price drops.
Speculation Opportunities
Crypto derivatives provide ample opportunities for speculation, allowing traders to profit from both upward and downward price movements without owning the underlying asset. With futures and options contracts, traders can take leveraged positions to amplify their gains (or losses) based on price predictions.
However, it’s important to note that leverage can also amplify losses, and the cryptocurrency market’s volatility can lead to significant price swings, potentially resulting in substantial losses. This flexibility attracts traders seeking to capitalise on short-term price fluctuations in the cryptocurrency market.
Increased Market Liquidity
Introducing crypto derivatives has contributed to increased market liquidity in the cryptocurrency ecosystem. Futures contracts and perpetual swaps facilitate trading volume by allowing participants to enter and exit positions more quickly.
Enhanced liquidity benefits traders by reducing slippage and improving price discovery. It ultimately makes it easier to execute large trades without significantly impacting the market.
Diversification of Investment Strategies
Crypto derivatives enable investors to diversify their investment strategies beyond buying and holding cryptocurrencies.
By incorporating derivatives into their portfolios, investors can access a broader range of trading strategies, including arbitrage (taking advantage of price differences in different markets), options writing (selling options to earn premium income), and spread trading (simultaneously buying and selling two related assets to profit from the price difference).
This diversification can help manage risk and enhance overall portfolio returns.
Access to Institutional Investors
The availability of regulated crypto derivative products, subject to oversight and rules set by regulatory authorities, has attracted institutional investors to the cryptocurrency market. Institutional participation brings additional liquidity, stability, and credibility to the market, further legitimising cryptocurrencies as a viable asset class.
However, it’s important to note that the regulatory landscape for crypto derivatives is still evolving, and regulatory changes could impact the market. The entrance of institutional players also paves the way for increased adoption and mainstream acceptance of cryptocurrencies as legitimate investment vehicles.
24/7 Trading Opportunities
Unlike traditional financial markets that operate within specific trading hours, crypto derivative markets are open 24/7. This continuous trading environment allows traders to react quickly to market developments and news events and fosters a sense of global community.
Traders worldwide can participate in crypto derivatives trading regardless of their time zone, creating an inclusive and global marketplace.
Risks Associated With Crypto Derivatives Trading
While crypto derivatives offer several advantages, they also have notable disadvantages that traders and investors should consider before engaging in derivative trading.
High Volatility and Risk
The cryptocurrency market is known for its extreme volatility, and derivative products amplify this volatility through leverage. While leverage can magnify profits, it also increases the potential for significant losses. Traders must exercise caution and implement robust risk management strategies to mitigate the inherent risks associated with crypto derivatives trading.
Regulatory Uncertainty
The regulatory landscape surrounding crypto derivatives remains to be determined in many jurisdictions. This lack of regulatory clarity can lead to legal and compliance risks for traders and exchanges offering derivative products. Regulatory changes or crackdowns could impact the availability and legality of specific derivative instruments, potentially disrupting trading activities and causing market uncertainty.
Market Manipulation
The cryptocurrency market’s decentralised and relatively unregulated nature makes it susceptible to manipulation. Manipulative practices such as spoofing, wash trading, and pump-and-dump schemes can artificially inflate or deflate prices, leading to significant losses for unsuspecting traders. Crypto derivative markets are particularly vulnerable to manipulation due to their lower liquidity and fragmented trading platforms.
Counterparty Risk
Derivative contracts typically involve counterparties, introducing counterparty risk into the equation. If a counterparty defaults on obligations or goes bankrupt, traders may suffer losses even if their underlying position is profitable. While reputable exchanges and clearinghouses mitigate counterparty risk to some extent, it remains a concern for derivative traders.
Complexity and Lack of Understanding
Derivative products can be complex financial instruments that require a thorough understanding of their mechanics and risks. Novice traders may need help to grasp the intricacies of derivatives, increasing the likelihood of costly mistakes. Additionally, the fast-paced nature of derivative markets can lead to impulsive decision-making and emotional trading, further exacerbating the risks involved.
Conclusion
Crypto derivatives such as Bitcoin futures can be game-changers for experienced traders, but they come with risks. Always start with a solid understanding of the market. This is a complex field, so take your time, research, and only invest what you can afford to lose.
Moreover, crypto derivatives trading can attract taxes based on your national jurisdiction. You need to keep track of all your gains from crypto derivative trading to file your taxes.
However, we understand this can be a hectic task for you. This is where KoinX steps in; it tracks your crypto profits and losses and accurately determines the crypto taxes you need to pay. So, sign up on KoinX today and confidently navigate your crypto journey!
