Crypto Derivatives 101

What are crypto derivatives?

For many people, the cryptocurrency market is still shrouded in mystery. However, in many ways this market is not much different from the stock market. Although one can’t deny that it’s unique in the sense that it involves a digital asset, how you trade cryptocurrencies and make a profit or a loss are quite similar. If you, for example, buy 100 Microsoft shares and the price doubles, you will double your investment. And if you buy 100 Bitcoins and the price doubles, you will also double your money. Just like in the stock market one can also use crypto derivatives to both generate profits and to hedge against risk.

What are Crypto Derivatives?

Generally speaking, derivatives consist of financial products of which the value depends on the price of a different asset. Specifically, they are derived from the price of that other asset, hence the name ‘derivative’.

Derivatives can be securities or contracts that derive their value from financial assets such as stocks, commodities, bonds, or interest rates. But nowadays that list also includes cryptocurrencies.

In the case of cryptocurrencies, the ways to make (or lose) money with derivatives are also quite similar to making or losing money on stocks, commodities, or other asset classes.

In this market, derivatives are often traded directly among buyers and sellers, but there are also exchanges where they can be traded. These businesses employ crypto exchange software to create platforms where crypto derivatives can be traded. How these markets are regulated is, however, somewhat different from conventional markets for stocks, or currencies.

Different kinds of Crypto Derivatives

Derivatives are typically divided into these types:

Options

Those readers who are familiar with stock options trading will already know how it works. If you believe Microsoft’s stock price will increase in the near future, you would buy a call option and if you believe it will drop, you will buy a put option.

You never have to own the actual stocks. And if the stock price goes in the direction you expected, you will benefit with the same amount as someone who actually holds that number of stocks – less what you initially paid for the option.

You can do the same with options on Bitcoin or other cryptocurrencies. If you believe the price will go up, buy a call option. If you believe it will go down, buy a put option. The profit/loss scenario remains much similar to when you trade options on stocks. If the price of Bitcoin goes up and you bought call options, you will make a profit. And if you bought put options, you will profit when it goes down.

You will be in much the same position as someone who actually owns Bitcoin, except for the initial cost of the options, which is only a fraction of the cost of the actual cryptocurrency.

Futures

Futures are standard contracts typically traded on exchanges. The futures buyer has to buy an asset at the previously agreed price on a previously agreed date. The buyer’s position at the end of the trade is very much the same as if he or she actually bought the underlying financial instrument, whether that be a stock, currency, or a cryptocurrency such as Bitcoin.

Perpetual Contracts

Perpetual Contracts do not have an expiry date. In other words, the trader can hold such a contract for however long he or she chooses and closes it whenever they wish. This type of contract can be extremely volatile since they are often utilized as a funding mechanism, so traders have to exercise extreme care when trading them.

Forwards

These are nearly identical to futures with one major difference: it’s possible to customize them to suit the needs of the individual trader. In this respect, they are more flexible than many other types of trading instruments. They are typically traded on an Over The Counter (OTC) basis.

Swaps

As the name indicates, this type of derivative is used when one type of cryptocurrency is exchanged for another one with the aim to make a profit at a fixed time in the (near) future. Let’s say you own Bitcoin and another trader owns Ethereum. Both of you believe that over the next month the other one will do better than the one you own. What do you do? You swap them.

How to trade the Crypto Derivatives using futures contracts

We will illustrate this example with oil as the physical asset, oil, and Bitcoin as the cryptoasset.

Example: Trading Oil Futures

Let’s say that you would like to speculate on the price of oil. One of your options is to physically purchase futures contracts for 100 barrels of oil. If the price goes up, you can sell it at a profit. If it goes down, you will make a loss.

You can decide to take delivery of your oil using your futures contracts. This is of course expensive and impractical. You will have to transport your 100 barrels of oil and rent space at a storage facility. A much better alternative is to trade contracts or instruments of which the prices are directly linked to the oil price, for example derivatives such as futures contracts.

Example: Trading Bitcoin Futures

The same trading principles apply when you believe the price of Bitcoin will go up. To create a market, there obviously has to be someone out there who believes that the price will come down. You and that other speculator now have the opportunity to sign a deal. This is after a specific period, let’s say a month, if the price has moved either up or down, one of you will have to pay the other one the price difference.

Let’s assume the price of Bitcoin (BTC) is currently $40,000 and you are convinced it will increase over the next month. The other trader believes it will go down. You decide to buy 10 Bitcoin futures contracts from him or her for $400,000 (10 x $40,000). If, at the end of the month, the price has reached $50,000 your trading partner will have to pay you 10 x $10 000 = $100,000. However, if the shoe is on the other foot and it goes down, you are the one that will be paying the $100,000.

How to trade the crypto derivatives using options

Before we even start with options, let’s make it quite clear that when using the term ‘option’ we are referring to vanilla options and not binary options. A vanilla option is a financial instrument that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a given timeframe.

Buying call options

Now let’s go back to our earlier example where BTC is trading at $40,000. If you believe the price will go up over the next month, you have many options. You can buy Bitcoin outright at its present value, or you can also buy BTC futures. In both cases, you risk the full $40,000 if the price doesn’t go up, but goes down dramatically to near zero.

Another option is to buy a 1-month Bitcoin call option. To keep things simple, let’s assume such an option currently sells for $400.

Now let’s examine how your position will compare to actually buying Bitcoin should the price go up, or down.

For example, say you paid $40,000 upfront on your Bitcoin (or Bitcoin futures), and the price after 30 days stands at $50,000, you will make a neat profit of $10,000 (less any transaction costs).

If it, however, drops to $30,000 you will make a loss of $10,000 (plus transaction costs).

If, on the other hand, you bought a 1-month Bitcoin call option with a strike price of $40,000 for $400 and the Bitcoin price goes up to $50,000, you will still make a profit of $10,000, less the $400 you paid for the option. Thus, you will only start making a profit after the price has increased by more than the $400.

Where the big difference comes in is if the price should drop to $30,000. Unlike with buying actual Bitcoin or futures, your loss remains limited to the amount you paid for the option. In the case above, this would be $400.

Purchasing put options

If you believe the BTC price will go down, you might want to buy what is known as a put option. The rest of the calculation remains the same as for call options, except for the direction of the price. If you are right, you will make $10,000 if the price drops to $30,000. And if it skyrockets you will not lose more than what you paid for the option.

Buying both call and put options

It’s also possible to buy both call and put options if you can’t make up your mind about whether the cryptocurrency of your choice will go up or down. Going back to the BTC at $40 000 example: you can buy a 1-month $40,000 call and a put for $400 each. The total cost of the put and call options being $800.

Now it doesn’t matter whether the BTC price goes up or down, you will make money provided it moves more than $800 in either direction. If it goes to $50,000, you will make $10,000 less the $800 you paid for the two options. If it goes to $30,000 you will also make the same amount of profit.

However, you are not in Bitcoin heaven yet. If the price moves less than $800 you will make a loss. Let’s assume it doesn’t move at all. Then you will lose the full $800. If it moves up or down $799, you will lose $1.

Looking at this from a potential risk/reward viewpoint, a vanilla call or option (or a combination of the two) is therefore a much better proposition than alternatives such as directly investing in cryptocurrencies. At least you won’t be walking out with only the shirt on your back if things go wrong. In case you want to read more about the subject: buying both a call and a put option is referred to in trading circles as a long straddle.

Platforms that support Crypto Derivatives

There are a number of trading platforms that support crypto derivative trading. We advise readers to thoroughly research any platform they decide to use. This includes looking up their reviews and trading history if possible. Referrals from trusted friends or contacts also should weigh on your decision. Don’t always trust the first ads you see on a search results page or social media websites. Do your homework and assume every platform is either unreliable or untrustworthy until your research tells you otherwise.

Other strategies for generating profit from crypto derivatives

There are many other trading strategies that can be used to generate profits and/or limit risks in cryptocurrency derivatives. Which one you use entirely depends on your view of what the market is going to do.

Optimistic about the market?

If you strongly believe the price of your favorite cryptocurrency will go up, you could buy futures contracts. For such cases, a long call option in our view has a better risk/reward profile.

Feeling undecided about crypto prices?

If you believe the market will break out to the upside or downside, but you are not sure which one, a long straddle (see above) is a perfect choice. The worst-case scenario is that you will lose both option premiums, but you have unlimited profit potential.

And if you are convinced the market will remain quiet and range-bound, a short straddle is your answer. This involves selling both a call and a put option. The risk profile looks like a little tent. As long as the price remains in the tent, you will make a profit. If it moves out of there, you are facing potentially unlimited losses.

Clueless about crypto prices?

Finally, for example, if you are stuck with Bitcoin that you believe is going nowhere, and you can find another trader who owns Ethereum, you can do a swap. To do this you need to:

– Open an account at a crypto swap exchange and verify your email
– Choose the cryptocurrency you wish to swap
– Enter the amount you want to swap
– Select and confirm the cryptocurrency you would like to exchange it for

There are several ways to swap cryptocurrencies for very little to zero fees, as Coinbase provides its users. Thus, having the ability to perform these quick and low cost transfers provides traders with low friction trading.

Wrap up

Like other forms of trading, cryptocurrency derivatives offer huge opportunities for profit, but also come with major risks. Arm yourself with knowledge. Make sure you know about all the different strategies to generate profits. But also make sure you know as much as possible about strategies to limit your losses to the minimum. You can only become a profitable long-term trader if you can successfully do both.