Bitcoin Derivatives

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Today’s emerging digital revolution is leading a radical shift away from the conventional monetary exchange model as digital money like cryptocurrencies come to prevalence in modern society. Despite cryptocurrency’s ubiquity, there is still an apparent need to drive mass adoption, and one way to do it is through crypto derivatives like Bitcoin futures. Just like traditional derivatives such as Futures and Options, crypto derivatives like Perpetual Swaps contracts also allow for equal if not higher leverage in the crypto markets than that of derivatives of the traditional financial markets.

Derivatives – What are they?

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A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial security. Common securities include bonds, commodities, currencies (or cryptocurrencies), interest rates, market indexes, and stocks. The value of a derivative is derived from the value of its underlying financial security, and this means that inherently, derivatives have no value to them. For example, a Bitcoin futures contract is a derivative contract that derives its value from its underlying asset – Bitcoin.

Traditional Derivatives

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The four primary forms of traditional derivatives are Options, Futures, Forwards, and Swaps.

Options – An Options contract enables a buyer and seller to transact with an asset at a predetermined price within a definite timeline, except that traders are not mandated to buy assets in this contract.

Futures – Contrasting to an Options contract, a Futures contract mandates a trader to either buy or sell an asset at a predetermined date and price.

Forwards – Customized to fit the needs of traders, Forwards contracts are normally conducted Over-the-Counter (OTC) on such exchanges with consideration of risk factors.

Swaps – Swaps contracts are made between two parties solely to profit by exchange currencies (crypto) at a future predetermined date. Common assets exchanged are bonds, notes, and loans. (E.g. Crypto Perpetual Swap)

Crypto Derivatives

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Like a traditional futures contract, crypto derivatives enable investors to gain exposure to Bitcoin without holding the underlying cryptocurrency and speculating on the future price of Bitcoin. However, the larger movement in the underlying cryptocurrency assets of crypto derivatives results in higher volatility, therefore allowing for a higher return.

According to a study done by Eurekahedge in 2019, crypto derivative funds like Bitcoin futures have a higher average return of 16% as compared to that of hedge funds at 10.7%, typically the top performing funds in traditional financial markets.

The first Bitcoin futures trading was launched by the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) in 2017 during the bullish crypto market.

For example, Bitcoin investor, Kimberly, buys a Bitcoin futures contract worth $10,000, she would gain exposure to $10,000 worth of price movements of the Bitcoin futures contract. Although Kimberly does not have ownership of the Bitcoin, she would still be able to experience akin profits or losses without having an actual trade of USD and Bitcoin.

Who are the Derivatives Traders?

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Arbitrageurs – Arbitrageurs are people who leverage on the price differences offered in different products and exchanges, resulting in them earning minimal profits, yet they improve the market efficiency simultaneously.

Market makers – Market makers capture bid-ask spread and take advantage of maker rebates, providing liquidity to both sides of the market.

Speculators – Speculators bet on price movements of the underlying assets of derivatives

Hedgers – Hedgers limit their exposure to market risks by trading with other open positions

An example of a crypto hedge derivative trader is a Bitcoin miner. A Bitcoin miner hedges their holdings against a price fall.

How can you Benefit from Trading Crypto Derivatives?

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Leverage – Trading with leverage makes it possible for crypto traders to control the same size as they would by holding a position on the underlying asset, but with a smaller amount of capital. E.g Derivative trading platforms like DigiDeriv offer up to a 100X leveraged trading. 

Lower fees – Unlike its underlying crypto spot market, crypto derivatives offer lower trading fees, even offering rebates for maker orders.

Net short positions – With up to 100X leverage crypto derivatives can offer, traders can take net short positions and profit from their trades even with falling prices. 

Hedging – Derivatives allow traders to lower their exposure to markets without selling their cryptocurrencies’ underlying assets. 

Capture price differences – Trading crypto derivatives allows traders to take advantage of price differences of a derivative and its underlying asset. This is possible even between two derivatives. 

Emerge of Crypto Derivatives

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As cryptocurrencies like Bitcoin take the lead in shifting the masses to take on crypto adoption, crypto derivatives are bound to emerge as a new digital revolution, diverting away from conventional monetary exchange models.

For related articles, read DigiFinex Academy.

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