What are derivatives?

Posted On May 8, 2022

You know what’s a mortgage. It’s a debt. You borrow money, and the loan is secured by the value of the property mortgaged. You know what equity is. Stock or share of a company, value that would be returned to shareholders if the assets were liquidated and debts paid off. 

Well, derivatives are the third major financial instrument. They are a contract. Their value is derived from an entity, usually, an asset, to which the contract refers to. The most typical derivatives are forwards, futures, options, and swaps.

Say, there is a commodity with a fluctuating price. A company can buy a futures contract, agreeing to buy that commodity at the current price. If the price at the time of delivery falls, the seller profits. If the price rises, the company can decide either to accept the delivery of the commodity at a safer, lower, ‘hedged’ price or sell the contract and profit from a price change. Now we can understand what is a cryptocurrency derivative.

What are derivatives in cryptocurrency?

Instead of commodities, currencies can be “the underlying asset”. This includes cryptocurrencies, which are anyways treated as assets by many legislatures of the world. Derivatives are not only used to hedge risk but also to speculate on the price of the underlying asset.

Cryptocurrency and its volatility have proved to be a very profitable playground for traders. Going long, holding onto your crypto, pays off if you believe that the price will go up. But the crafty speculators could decide to short the crypto.

Spot trading vs derivative trading

Spot trading is the usual trade done on exchanges, and it comes first to mind when cryptocurrency trade is mentioned. Many crypto exchanges started with only spot trading offerings. Basically, this means that you need to buy the cryptocurrency, actually hold it, and you profit from the price going up.

Shorting the position means that you borrow a cryptocurrency and promise to sell them at the current price. Then, if you are optimistic that the price will drop, you buy crypto at that time and repay the capital borrowed.

Cryptocurrency derivatives types

A cryptocurrency derivative allows traders to trade contracts. These follow the price of cryptocurrency and traders don’t have to actually own any. Let’s say you have a contract with another trader. You agree to settle your contract at a future time. If the price goes up, you pay the difference, if the price goes down, the other trader pays the difference.

Since neither of you must hold the said cryptocurrency (contract is connected to price fluctuation), that’s a derivative. This particular derivative type is called CFD (contract for differences). They are banned in the USA and UK because they are risky and not regulated. Fraudulent crypto platforms often use CFD instead of spot markets. It is quoted here just for your clarity on what is a derivative.

The most popular crypto derivatives are crypto futures, crypto options, and perpetual contracts.

Crypto Futures

This is a contract with a clear expiration date. Cryptocurrency derivative exchange matches traders going long (betting that the price will increase) and traders going short (betting that the price will decrease). When the contract expires, one of the traders will pay the other.

You can engage in this kind of trade at cryptocurrency derivatives exchange like Binance, ByBit, FTX, KuCoin, Kraken, or Poloniex.

Crypto Options

This is the contract with an option to buy or sell at the expiration date. Instead of going long or going short, traders can call or put. The call option means you have the right to buy the cryptocurrency at an agreed price once the contract expires. A put option gives you the chance to sell the cryptocurrency at an agreed price once the contract expires.

With either call or put, it is entirely up to the owner whether they choose to enact their right, which is why these derivatives are called – options.

These contracts have a price called – a premium. When a contract expires without traders exercising their rights, they still lose the premium they’ve paid for the option. Thus these contracts minimize the risk but don’t eliminate the losses.

Perpetual contracts

Perpetual contracts are derivatives that, unlike other cryptocurrency derivatives, have no expiration and settlement dates. Traders can keep their positions open, under certain conditions. There is a minimum cryptocurrency to be held (margin). Also, there is a funding rate to be considered.

If there are too many long positions, the price of the cryptocurrency will rise above the spot price. It’s called a positive funding rate, and there is no incentive for other traders to go short. So, in perpetual contracts, when a positive funding rate occurs, all traders at long positions must pay shorts. If the opposite happens, if the price drops below the spot price, then it’s a negative funding rate and the short position traders have to pay longs. This helps the market move towards the actual price by incentivizing traders to take opposite directions. The payments are made directly between traders.

Exchanges carrying this kind of product are cryptocurrency derivatives exchange like Binance, Perpetual, and PancakeSwap.