Experienced traders leverage a variety of financial instruments to capitalize on the volatility of markets. In many cases, these tools can help lessen the risks that come with trading. For crypto traders, derivatives have become such a tool, helping traders hedge and manage risks.

In today’s post, we’ll go over cryptocurrency derivatives and answer the following questions:

What are cryptocurrency derivatives?

How are derivatives used in crypto trading?

What are the pros and cons of crypto derivatives?

What are cryptocurrency derivatives?

A derivative is a financial contract between two or more parties for the future purchase or exchange of the underlying asset. There are multiple types of derivatives, but the main four are futures, forwards, swaps, and options.

Futures - an agreement that obligates both parties to buy or sell the underlying asset at a predetermined price on a specific date in the future. The contracts are standardized and available for trade on an exchange.

Forwards - conceptually similar to futures. However, the contract is customized (non-standardized) to meet both parties’ needs. They’re traded over the counter (OTC) and therefore carry some risk.

Swaps - an agreement to exchange one kind of cash flow for another in the future. Swaps are usually based on underlying assets that bear interest, such as loans and bonds.

Options - a contract that grants the buyer or seller the right to buy or sell an asset at a predetermined price by a specified time.

How are derivatives used in crypto trading?

Long-term volatility protection

Cryptocurrencies are notoriously volatile. Derivatives can reduce long-term price volatility. By signing a contract that settles directly to an underlying price, derivatives can help major traders reduce their risk exposure and protect themselves from price fluctuations of the underlying asset.

Risk management

Investors can also use derivatives to offset potential losses. For example, if done correctly, a drop in asset values can be offset by the increase in value of put options.

Speculation

Traders who are confident that the price of an asset is nearing a downtrend may sell derivative contracts in the open market to those who think otherwise.

Pros and Cons of Crypto Derivatives

Cryptocurrency derivatives offer plenty of advantages but not without challenges and limitations.

Pros

Gain access to the cryptocurrency market without having to hold any crypto.

Opens up more sophisticated trading strategies.

Derivative contracts serve as risk mitigation for many traders during price fluctuations from the underlying asset

Access to otherwise unavailable assets or markets

The derivative market can generate signals and insights into market movement

Cons

The inherent sophisticated design of these contracts can make valuation extremely complicated, or even impossible. Thus, they bear a high inherent risk.

OTC transactions don’t always follow compliance procedures which can pose risks for traders.

While derivatives can help mitigate long-term risks, short-term fluctuations can still lead to substantial losses.

Conclusion

Derivatives are an important financial instrument for managing investment risks. Since major traditional exchanges like CBOE and CME launched Bitcoin futures at the end of 2017, the market has excitedly looked forward to cryptocurrency-based derivatives products. However, caution is strongly advised given the complex and sophisticated nature of derivatives.