Speculators and proponents of aggressive investment strategies widely use standard exchange-traded and over-the-counter derivatives to generate profits. Many of them are also seriously interested in assets such as crypto derivatives (derivatives on cryptocurrency).
From this article you will learn:
- Traders use crypto derivatives to profit from volatile markets.
- Aggressive investors employ tools like futures and options to boost their earnings.
- Crypto derivatives act as a hedge for conservative investors and miners against falling cryptocurrency prices.
What Are Crypto Derivatives?
Crypto derivatives are a general term for futures contracts (derivative financial instruments) where the underlying assets are cryptocurrency rates. Most of these contracts are cash-settled, meaning they don’t involve the actual transfer of tokens but allow for profit from the rise in the coin’s value. This can be particularly attractive to traders engaged in speculative operations and aggressive investors due to the high volatility in the crypto market.
In fact, the list of these instruments includes the same tools used with assets in other markets, such as stock, currency, or commodities. These include:
- A futures contract obligates one party to buy and the other to sell an agreed volume of cryptocurrency at a specified price upon expiration. With cash-settled futures, one party pays the other the difference between the purchase price and the current price at settlement. Futures are standardized contracts traded on exchanges, involving a central counterparty to ensure obligations are met by both sides. One attractive feature is the margin requirement, which can be 2% to 20% of the contract’s value, enabling leveraged trading.
- Over-the-counter contracts similar to futures, obligating both parties to execute a transaction in the future on agreed terms. The key differences are the lack of standardization, absence of a central counterparty, and no margin requirement, increasing risk. Forwards are less common and typically used by investors interested in actual crypto asset purchases.
- A type of futures contract giving the buyer the right to buy or sell cryptocurrency at an agreed price upon expiration. The seller, in turn, must fulfill the transaction upon request. This instrument is popular among speculators since the buyer’s risk is limited to the premium paid, while potential profits are unlimited. Both standardized exchange-traded and over-the-counter options, where the deal details are negotiated between parties, are available.
- CFDs (Contracts for Difference). Derivative instruments where parties settle the difference in prices at the contract’s start and end. If the price rises, the buyer profits, with the seller making the payment, and vice versa if the price falls. CFDs are similar to spot transactions but can have a specified execution date and typically involve leverage, which can be higher than in uncollateralized margin trading on the spot market.
Today, even retail investors can easily find options for trading crypto derivatives.
Platforms for Trading Cryptocurrency Futures
Back in 2017, the Chicago Mercantile Exchange (CME) launched trading for standard Bitcoin futures. Since February 2021, CME has also offered Ethereum futures, and since May 2021, it has introduced Micro Bitcoin Futures with a base asset of 1/10 BTC. This allows investors to allocate their capital into crypto assets without the need for actual token exchange, dealing with wallets, or worrying about security.
Futures contracts are available on almost all major cryptocurrency exchanges. For instance, Binance has a separate section for trading called Binance Futures. These contracts are based on the rates of most cryptocurrencies listed on the exchange, paired with fiat currencies or other tokens.
Many cryptocurrency exchanges offer non-standard futures contracts, such as perpetual futures. These are exclusively cash-settled, with investors independently realizing profit or loss by closing (selling a purchased contract or buying a sold contract) at any time. However, such derivatives share all the key characteristics of standard futures contracts, including margin requirements and the calculation, accrual, and deduction of variation margin.
Trading CFDs on Cryptocurrencies
Many licensed forex brokers now offer contracts for difference (CFDs) on cryptocurrency assets. These can also be found through dealing centers without official regulatory licenses, but which have successfully provided interbank and over-the-counter trading services for many years (e.g., Alpari, ForexClub, and others).
Legislation regulating the trading of digital assets has yet to be fully established in almost any country. Therefore, even licensed companies often operate through subsidiaries registered in offshore jurisdictions, where the requirements for financial services and their quality are considerably more lenient.
Why Use Crypto Derivatives?
The primary users of cryptocurrency derivatives are traders engaged in speculative trading. Aggressive investors also use them to increase their returns. The main instruments for these market participants are futures, CFD contracts, and options.
Crypto derivatives are often used as tools for hedging risks. In this capacity, they are used by:
- More conservative investors, who have part of their portfolios invested in crypto assets. Purchasing options can serve as a good hedge against price declines.
- Miners and owners of mining farms, for whom a put option can provide excellent insurance for their business’s profitability during periods of falling prices.