What's Crypto Derivatives?
A derivative is simply a financial contract between two or more parties that derive (therefore, "derivatives") the value from an underlying asset, in this case, cryptocurrencies. More specifically, it is an agreement to buy or sell a particular asset, whether stocks or cryptocurrencies, at a predetermined price and a specific time in the future.
Derivatives have no inherent or direct value in themselves. The value of a derivative contract is based only on the expected future price movements of the underlying cryptocurrency.
Here Are The 3 Most Common Types of Derivative Products
Swaps: A swap is an agreement between two parties to exchange a series of cash flows in the future, usually based on interest-bearing instruments, such as loans, bonds or promissory notes, as an underlying asset. Interest swaps are the most common form of swaps. They involve the exchange of a future stream of fixed interest payments against a floating rate payment stream between two different counterparties.
Futures: A financial contract in which a buyer has an obligation to buy an asset or a seller to sell an asset (such as commodities) at a fixed price and a predetermined future price.
Options: A financial contract in which a buyer has the right (and not an obligation) to buy an asset or a seller to sell an asset at a predetermined price within a specified time.
Because the cryptocurrency derivatives market is still in its infancy, currently, the public has only a few derivatives. The most common derivatives of cryptocurrency are Bitcoin futures and options, since Bitcoin controls more than 50% of the total market capitalization of cryptocurrency, making it the most important and the most exchanged currency in the world.
3 Reasons To Trade Derivatives
1.Mitigate the risk of volatility in price
The most fundamental reason that derivative exists is that it reduces the risk for individuals and companies and protects themselves from any volatility in the price of the underlying asset. Here is an excellent example of how derivatives can be used to mitigate risks.
Suppose that you have decided to subscribe to a sports car magazine to keep yourself updated on the fancy cars. As the purchaser of the service, you agree with the publishers to allow you to obtain a specified number of magazines at a fixed monthly price for one year. This is similar to a futures contract, in which you specify the exact price you will pay and the exact product/service you will receive during the specified period of 1 year.
In other words, you have secured the monthly magazine for a full year, knowing that you will pay a fixed price, even if the price of cable TV increases during the year. By entering into this agreement, you reduce the risk of having to pay a higher monthly price throughout the year. How great is that!
Another good example I would like to share is banana farmers who are trying to ensure the cost doesn't go above the budget and projecting the sales and profit for the next season's grains production. Since the price of banana fluctuates daily depending on market conditions, the banana farmer could protect himself from the volatility of daily price fluctuations by securing a future contract that guarantees the price to be sold to the market in the upcoming future. Similarly, companies can also use derivatives to reduce the risk of price fluctuation. A supermarket trying to buy banana from the farmer would use a contract to secure the price of wheat flour for the year. This ensures that the company can project for the year and protect against fluctuations in banana prices.
Investors may also use derivatives to protect their investment portfolios. This is also called "hedging", which involves taking action to compensate for potential losses. Derivatives are a vital risk management technique for institutions and investors. The concept of coverage is similar to owning an insurance policy for your portfolio. Here is an example to illustrate a coverage scenario:
Suppose you are bullish on Alibaba (BABA), and you have a significant amount of BABA stock. However, you are running a considerable risk. If the US economy was suffering from systemic shock or bad news, you can be sure that the BABA prices would fall and reduce your investment capital. You can use derivatives - in the form of options contracts - to reduce your overall investment risk. By using a type of option called "put options", you can take advantage of your options contract as their value will increase when the price of the underlying asset (in this case BABA shares) decreases.
That being said, if you own BABA shares and are worried about unforeseen circumstances that could negatively impact your portfolio, you can buy derivatives to protect your investments and compensate for potential losses. Although the principal value of your BABA investments is decreasing, the boost in the value of your put options derivatives will offset the overall losses. Depending on factors such as experience and expertise in derivatives, an investor or trader can be profitable in any situation, be it a bull or bear market.
The Hedge could save you potential headaches or worries you may encounter during your investment journey. Having an insurance policy using derivatives allows you to manage your risks well and, above all, to eat and sleep well!
Traders often use leverage to speculate on cryptocurrency prices, with the intention of profiting from changes in the price of the underlying cryptocurrency. For example, a trader may attempt to take advantage of an anticipated decline in general cryptocurrency prices by "shorting" the coin. Shorting - or short selling - refers to the act of betting against the price of a security. Speculation is invariably considered undesirable because it injects a higher degree of volatility to the overall market.
Traditionally, one of the ways to profiting from crypto-currencies - or any other title in this case - is to buy a coin at a low price and later resell it at a higher price. However, this can only be done in a bull market or when the market is on the rise. Shorting is a way to profit from a bear market or when the market is down.
The simplest way to "sell short" is to borrow a security from a third party (a stock exchange or broker) and sell it immediately to the market, as long as you expect a drop in prices. You can return it to the market once prices have fallen and buy back the same amount of securities you sold initially. So settle your account with third parties. In this case, you will benefit from the initial sale of the securities and their redemption at lower prices.
A simpler solution is to use derivative contracts because they are much cheaper and "profitable". If anyone thinks that crypto-currency prices are unsustainable or will soon see a downward trend, he or she could sell derivative contracts in the open market to anyone who thinks otherwise (that the market will go up).
What are Bitcoins Options?
Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an asset at a specific price on a predefined future date.
Options are particularly common in the currency and commodities markets, but you can also buy options on other financial assets such as stocks, bonds, indices, and of course, bitcoins.
Why Trade The Bitcoin Options?
There are two reasons for exchanging bitcoin options: speculation and coverage. If you want to speculate on the price of bitcoin up to $10,000 over the next three months, you can either buy bitcoin (BTC) and keep it for three months or buy bitcoin options, for a small fee, with an exercise price of $10,000, and a maturity of three months. By buying bitcoin options, you bet that the price of bitcoin will exceed $10,000, and you will be "in the money" on this bet when the price is higher than the exercise price of $10,000.
You only have to pay a small premium (price) for Bitcoin options. Therefore, you can buy a large number of options to generate high returns in the event that the options are in the money. If the options expire "out of the money" (below the $10,000 exercise price), you lose the entire amount invested.
You can also use bitcoin options to cover your digital asset portfolio. This is how many professional investors use Bitcoin options.
To cover your digital asset portfolio with bitcoin options, you can, for example, purchase a bitcoin put option with an exercise price of $3,750 (25% lower than the current BTC price), and a six-month deadline. If the price of bitcoin drops by more than 25%, which would probably result in a drop of just over 25% in your diversified digital asset portfolio, you would be partially protected against further losses because your options would be then "in-the-money" to compensate for the fall in the value of the portfolio.
It will be up to you to decide on the hedge ratio, which will determine the portion of your portfolio that will be hedged in the event of a market downturn. If you choose a hedge ratio of 1, this means that your portfolio will be fully hedged if the market corrects. However, it will cost you more because you will have to buy more options. As a result, the price of the options will be reduced by the potential profit if the market recovers and the options expire.
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