A crypto derivative is a contract or product whose price is determined by an underlying asset such as commodities, stocks, exchange rates, currencies, and interest rates. This mechanism allows buyers and sellers to bet on the future value of the underlying asset to make a profit.
This article explores all the basics of derivatives and crypto derivatives trading so that you are better informed.
Derivatives Trading – The Primitive Concept
In derivatives trading, the underlying asset can be any cryptocurrency token where buyers and sellers enter into a financial contract. This contract speculates the price of the cryptocurrency at a future date.
• During its first phase, the contract allows both parties to agree on the sale/purchase price of the cryptocurrency token on a specific day. This price is independent of the market price and is not affected by the fluctuations associated with it.
• Thus, investors can benefit from the price changes of an asset in two ways. They can buy at a cheaper price or sell at a higher price.
Where do you trade derivatives?
You can trade cryptocurrency derivatives on centralized exchanges. Furthermore, most decentralized exchanges allow this type of trading. These derivatives trading platforms are more flexible than any spot margin trading which gives you access to different and unknown markets.
Types of Cryptocurrency Derivatives – Most Popular Choices in the Market
Depending on the original terms of the contract, crypto derivatives can be one of the following types.
• Futures: A forward contract is a legal agreement between a buyer and seller. It involves buying or selling an underlying asset at a predetermined price and date in the future.
• Cucumber : Options give the trader a choice but eliminate the responsibility to buy or sell the underlying asset at a certain value at a future date and price.
• Permanent Contracts: A perpetual contract, unlike futures or options, has no expiration or settlement date. Under specific conditions, traders open their positions to trade indefinitely.
• Character: A swap is a contract to exchange cash flows at a future date under a predetermined equalization procedure. These are over-the-counter (OTC) contracts and are not traded on regulated exchanges.
• Attackers: A futures contract is a derivative instrument that uses a non-standard contract to trade the underlying asset at a future time and price.
Basic Features of Derivatives Trading
# 1. Stop/Loss Take Profit:
Stop/Loss Take Profit is a mechanism that allows traders to set floor and ceiling values for a particular order. As a result, they can automatically exit the market when conditions become profitable.
# 2. Automatic Deleveraging (ADL):
The ADL system of cryptocurrency exchange automatically de-leverages the opposite position from the particular trader when the position cannot be liquidated at a price above the breakout price. The ADL also works if the insurance is not sufficient to cover the loss arising from the contract.
# 3. Partial Closing Orders:
This feature allows traders to make partial gains by partially closing their orders while still making consistent profits from the growing market.
• Reduced transaction fees: In general, derivatives are risk management tools and therefore have a lower cost of market transactions, unlike other securities such as spot trading.
• Risk Management: The price of the value of a cryptocurrency has to do with the value of the contract. For this reason, traders use these derivatives to mitigate the risks associated with fluctuations in the prices of the underlying assets. Moreover, these risks are transferable to others.
• Effective: The practice of arbitrage in derivative contracts ensures that the market finds its equilibrium once the price of the underlying asset is accurate.
Disadvantages of using derivatives
• My very guess: There is no denying that derivative contracts work better as speculative instruments. This risky nature makes the process unpredictable, resulting in huge losses.
• Heavy risk factor: Although derivatives help mitigate the price volatility risk of the underlying digital currencies, they are undoubtedly highly volatile. This happens due to the fluctuating value of cryptocurrencies after closing the contract, which comes at the expense of the trader’s money.
Final Thoughts – The future of the derivatives market
According to experts, the crypto derivatives market is witnessing an increase in trading volume in the coming years. In the third quarter of 2020, the trade volume was about $2.7 trillion, an increase of 25.1% compared to the previous quarter. This massive growth will appear in 2022 as the market continues to grow and traders all over the world are engaged.
Read also: Getting started in the world of cryptocurrency: What you need to know