We earlier discussed Derivatives, its forms, and how it benefits a Bitcoin investor.
Quick Recap:
- A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial security
- Four primary forms of derivatives – Options, Futures, Forwards and Swaps
- Larger movements in the underlying cryptocurrency assets of crypto derivatives results in higher volatility, therefore allowing for a higher return
- Four types of derivatives traders – Arbitrageurs, Market makers, Speculators and Hedgers
- Five benefits from crypto derivatives – High leverage, lower fees, net short positions, hedging and price difference captures
A study done by Eurekahedge in 2019 has revealed that 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. In addition, crypto derivatives like Perpetual Swap contracts also allow for equal if not higher leverage in the crypto markets than that of derivatives of the traditional financial markets – But what are they?
The Perpetual Swap Contract
Perpetual swaps are a type of derivative, like a futures contract but without an expiry date. When a trader opens a perpetual swap trade, h/she is essentially betting on the value of an asset, whether it will rise or fall, or pay funding fees. As a perpetual swap contract has no expiry date, both parties are allowed to keep their positions as long as they hold enough BTC, or margin, to cover them in their account. In essence, perpetual swap contracts are standardized contracts that allow traders to hold a position for as long as h/she wants to profit from the increase of a cryptocurrency’s price (Long position) or sell to potentially profit from the decline of a cryptocurrency’s price (Short position).
Mechanisms of a Perpetual Swap Contract
In contrast to derivatives like options and standard futures, where the price of the contract and its underlying asset converges upon contract expiration, a perpetual swap contract does not have a predetermined date to buy or sell an asset. Perpetual Swap contracts instead, uses a mechanism called the “Funding Rate”.
The funding rate mechanism keeps the price of a perpetual swap contract consistent with its underlying asset price, preventing major price fluctuations. However, traders should be aware that the funding rate is a fee exchanged between two parties (long & short) of a contract, and not a transaction fee by the crypto exchange. Even short position traders would keep their contracts open with the rise in value of a perpetual contract with the funding rate mechanism. The funding rate however, varies and is determined by the market.
Negative & Positive Funding Rate
In a scenario when longs pays and shorts receives funding, it is positive funding. Contrasting to that of positive funding, negative funding is when shorts pay and longs receive the funding. However, it should be noted that only traders who held positions at the funding timestamps will pay or receive funding, should the position be closed before settlement, traders will not be required to pay or receive funding. This way, the funding rate mechanism balances the demand of buyers and sellers for the perpetual swap so that its price falls in line with its underlying asset.
Benefits at a Glance
No Expiration
Hold a position forever with the magic of funding rate mechanism. No headache over rolling over positions like in futures contracts.
Earn MORE with less
Trade with up to 100x leverage at derivative trading platforms like DigiDeriv. Easily control the size of your crypto trade by holding a position of the underlying asset with less capital.
E.g A BTC/USD pair is trading at $10,000, but you could only buy 1 BTC in spot markets with a $10,000 collateral. When you trade with perpetual swap with up to 100x leverage, you could get 100 BTC with the same $10,000 collateral.
Liquidity
Perpetual swap is one of the most popular and traded products on our platform, resulting in strong liquidity profiles. Be assured to jump on the bandwagon with ease regardless if you’re a buyer or seller.
What to Look Out for
High Risks
Risk is an inherent factor in all forms of investment. Although derivatives offers high leverage, the higher the leverage, the lower the downside protection you will get before your position gets liquidated.
High Funding Rates
The mechanics of funding rates work against popular trades. For example, should most traders hold long positions and if you follow the trend, very likely you will be paying funding rate fees to short position traders who are maintaining the price of the perpetual swap contracts – This results in lower returns for consensus positions.
Choosing a Derivatives Exchange
Fair System
It is crucial that a Derivatives Exchange ensures a fair system away from extreme volatility. Traders should take note of the exchange’s margin requirements, e.g Higher initial margin for a higher position that minimizes liquidation and deleverages traders.
Global Identity
The more renowned an exchange is, the less likely traders will fall into scam because of the scrutiny from the public eye. It is recommended that traders choose an exchange with solid years of establishment and growing number of users, such as DigiDeriv by DigiFinex.
Methods of Purchase
Regardless of whether you are a beginner or a seasoned trader, you would want to choose an exchange that offers convenient methods of purchasing cryptocurrency, such as with visa or mastercard. That way, you get convenience along with efficiency.
In Summary
While derivatives like perpetual swaps offer high leverage that allow traders to earn more with less, it is up to individuals to consider the risks and fees when engaging in derivatives trading. For more related articles, read DigiFinex Academy.
