Bitcoin and cryptocurrency derivatives are becoming the way of life for serious crypto traders.
What’s a Derivative?
A derivative is a contract between two or more parties whose value is based on a pre-agreed underlying financial asset. Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes, and stocks.
Types of derivatives
There are three types of derivatives in the financial markets. These include:
- Futures: These are derivatives or financial contracts where an investor/trader has a commitment to buy or sell an asset, e.g. a cryptocurrency, at a fixed price on a predetermined future date.
- Swaps: These are financial contracts where two parties agree to exchange a number of cash flows in the future. They are normally based on instruments that are interest-bearing like bonds, loans, or notes.
- Options: These are financial contracts where an investor/trader is entitled to buy or sell a certain asset. For example a cryptocurrency, at a predetermined price within a specified timeline. The best-known forms of Options in the financial markets are the Binary Options that involve fiat currencies.
What are cryptocurrency derivatives?
A derivative is a financial contract between two or more parties based on the future price of an underlying asset. Financial derivatives are discussed a lot when it comes to the crypto industry, especially concerning futures contracts for Bitcoin or altcoins. It is worth noting that the derivative is one of the oldest forms of a financial contract that exists on the market.
Reasons to trade crypto derivatives
1.Mitigate the risk of volatility in price
The most fundamental reason that derivatives exist is that it reduces the risk for individuals and companies, and protects themselves from any volatility in the price of the underlying asset.
A futures contract is similar to subscribing to a monthly magazine. When you decide to sign up for a yearly subscription, at the moment of the agreement, the price per month you will pay for one year will be the same price and it cannot change over that time period.
In other words, you have secured the monthly magazine for a full year, knowing that you will pay a fixed price. By entering into this agreement, you reduce the risk of having to pay a higher monthly price throughout the year.
Investors may also use derivatives to protect their investment portfolios. This is also called “hedging”, which involves taking action to compensate for potential losses. Derivatives are a vital risk management technique for institutions and investors. The concept of coverage is similar to owning an insurance policy for your portfolio. Here is an example to illustrate a coverage scenario:
Suppose you own some stocks of the American brand “X”. In the hypothetical scenario that the US economy was suffering from bad news, most likely the price of “X” would go down and so reduce your investment capital. You can trade derivatives – in the form of options contracts – to reduce your overall investment risk. By using a type of option called “put options”, you can take advantage of your options contract as their value will increase when the price of the underlying asset decreases.
The Hedge could save you potential headaches or worries you may encounter during your investment journey. Having an insurance policy using derivatives allows you to manage your risks well.
Traders often leverage derivatives to speculate on cryptocurrency prices, with the aim of taking advantage of changes in the price of the underlying asset. For example, a trader may attempt to take advantage of an anticipated decline in general cryptocurrency prices by “shorting” the coin. Shorting – or short selling – refers to the act of betting against the price of a security.
Traditionally, one of the ways to profit from cryptocurrencies is to buy a coin at a low price and later resell it at a higher price. However, this can only be done in a bull market or when the market is on the rise. Shorting is a way to profit from a bear market or when the market is down.
The simplest way to “sell short” is to borrow a security from a third party (a stock exchange or broker) and sell it immediately to the market, as long as you expect a drop in prices. You can return it to the market once prices have fallen and buy back the same amount of securities you originally sold. So settle your account with third parties. In this case, you will benefit from the initial sale of the securities and their redemption at lower prices.
A simpler solution is to use derivative contracts because they are much cheaper and “profitable”. If anyone thinks that crypto-currency prices are unsustainable or will soon see a downward trend, he could sell derivative contracts in the open market to anyone who thinks otherwise (that the market will go up).
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