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This guide to crypto derivatives takes an introductory look into an interesting development, tackling a core question on what is cryptocurrency derivatives.

Overview

The cryptocurrency market has blossomed into a diverse ecosystem of over 2,000 coins and tokens, with each of them focusing on a specific type of application and use case that is built using the revolutionary blockchain technology. Though the infrastructure supporting the cryptocurrency world is still in its early stages, there are various developments that would warrant greater exposure and awareness of cryptocurrencies. One such advancement is the introduction of a cryptocurrency derivatives, which is a brand-new line of financial products. The most common form of cryptcurrency derivatives at the moment is Bitcoin futures, which received a mixed reaction among the community.

The popularity of Bitcoin futures is apparent when we look at the average trading daily volume, which has seen an increase of more than 40% in the third quarter of 2017. In monetary terms, the average daily volume of Bitcoin futures stood at 5,053 contracts, with a cumulative value of approximately $177 million. This data is pretty impressive, especially if we take into consideration that the cryptocurrency market has been in a recession since the start of 2018, where the general prices of coins and tokens have plummeted by more than 85%!

(Source: Investopedia)

Greater trading volume is an indication of good liquidity, which is always a good thing for market participants. This reflects a growing and healthy marketplace.

(Read more: How Will Bitcoin Futures Affect Bitcoin Prices? Here’s What History Says)

What are Crypto Derivatives?

Before we move on, let’s try to understand the universe of cryptocurrency derivatives.

A derivative is simply a financial contract between two or more parties that derives (hence ‘derivatives’) its value from an underlying asset, in this case, cryptocurrencies. More specifically, it is an agreement to buy or sell a particular asset – be it stocks or cryptocurrencies – at a predetermined price and a specified time in the future.

Derivatives do not have inherent or direct value by themselves; the value of a derivative contract is purely based on the expected future price movements of the underlying cryptocurrency.

There are 3 common types of derivatives product in the financial world:

The three main forms of derivatives are:

Swaps: A swap is an arrangement between 2 parties to exchange a series of cash flows in the future, usually based on interest-bearing instruments such as loans, bonds or notes as the underlying asset. The most common form of swaps are interest swaps., which involves the exchange of a future stream of fixed interest rate payments for a stream of floating rate payments between 2 different counter-parties.

A swap is an arrangement between 2 parties to exchange a series of cash flows in the future, usually based on interest-bearing instruments such as loans, bonds or notes as the underlying asset. The most common form of swaps are interest swaps., which involves the exchange of a future stream of rate payments for a stream of floating rate payments between 2 different counter-parties. Futures: A financial contract where a buyer has an obligation for a buyer to purchase an asset or a seller to sell an asset (such as commodities) at a fixed price and a predetermined future price.

A financial contract where a buyer has an for a buyer to purchase an asset or a seller to sell an asset (such as commodities) at a fixed price and a predetermined future price. Options: A financial contract where a buyer has the right (not an obligation) to purchase an asset or a seller to sell an asset at a pre-determined price by a specific timeline.

Due to the infancy of the cryptocurrency derivatives market, there is only a few derivatives products available for the public at the moment. The most common cryptocurrency derivatives are Bitcoin futures and options, due to the fact that Bitcoin controls over 50% of the entire cryptocurrency market capitalization, making it the largest and most-traded coin around.

(See also: Will A Crash in Bitcoin’s Price Lead to Its Demise?)

Reasons For Trading Derivatives

Derivatives are highly complex financial instruments that is used by advanced or technical investors. There are two main reasons for the use of derivatives, which include:

1. Protection from Volatility

The fundamental reason for the existence of derivatives is for individuals and corporations to reduce their risk exposure and protect themselves from any fluctuations in the price of the underlying asset. Here’s a real-life example that explains how derivatives are used to offset risks:

Imagine if you’ve decided to get a cable TV subscription to watch your favorite channels. As a buyer of the service, you will enter into a fixed agreement with the cable company to allow you to get a specified number of channels at a monthly fixed price for a period of 1-year. This is similar to a futures contract, where you specify the exact price that you’re going to pay and the exact product/services you’re going to receive within the specified period of 1-year. In other words, you have secured the monthly pricing of cable TV channels for a full year, knowing full well that you’re going to pay a fixed price no matter what, even if the price for cable TV rises during the year. By entering into this agreement, you reduce your risk of having to pay a higher monthly price throughout the year.

This is how derivatives work, except instead of cable TV, a rice farmer may be trying to secure sales of next season’s produce. Since the price of rice fluctuates on a daily basis depending on market conditions, the rice farmer would be keen to fix the price the next year’s harvest so that he would be protected from the volatility of daily price fluctuations. Businesses would also need to use derivatives to reduce their risk exposure. A bakery trying to buy wheat flour from a farmer would use a derivative contract to ‘lock-in’ the price of wheat flour for the year. This ensures that the bakery business can forecast its budget for the business year and protect itself from the fluctuations of wheat prices. It is these derivatives contracts between a buyer and seller that can be traded in the derivatives market.

(Read also: Guide on Identifying Scam Coins)

2. Hedging (Insurance Policy)

Investors could also use derivatives to protect their investment portfolio. This is also called ‘hedging’, which entails taking measures to offset potential losses. Derivatives serve as a vital risk management technique for institutions and investors. The concept of hedging is similar to owning an insurance policy for your portfolio. Here is an example to illustrate a hedging scenario:

Assume that you are bullish on Apple (AAPL) and owns a significant amount of AAPL stocks. However, there is a tremendous amount of risk that you’re holding; if the American economy suffered from a systemic shock or bad news, you can be sure that AAPL prices would tumble and reduce your investment capital. You can use derivatives – in the form of options contracts – to reduce your overall investment risk. Using a type of options called ‘put options’, you can profit from your options contract since they will increase in value when prices of the underlying asset (in this case AAPL stocks) goes down. So, if you own AAPL stocks and are worried about the unforeseen circumstances that can adversely affect your portfolio, you can buy derivatives to protect your investments and offset the potential losses. Although the main value of your AAPL investments drops in value, the increase in the value of your put option derivatives will offset the overall loss. Depending on factors such as experience and expertise in derivatives, an investor or trader could be profitable in any situation, be it a bull or bear market.

Hedging could save you from potential headaches or worries that you might face in your investing journey. Having an insurance policy by using derivatives ensures that you manage your risks well and more importantly, allows you to have a good night’s sleep!

(See more: Cryptocurrencies: A New Asset Class for Institutional Investors?)

3. Speculation

Traders often utilize derivatives to speculate on the prices of cryptocurrencies, with the main objective of profiting from the changes in the price of the underlying cryptocurrency. For instance, a trader might attempt to profit from an anticipated drop in the general prices of cryptocurrencies by ‘shorting’ the coin. Shorting – or short-selling – refers to the act of betting against the price of a security. Speculation is often viewed negatively since it adds a higher degree of volatility to the overall marketplace.

Traditionally, the way to profit from cryptocurrencies – or any securities for that matter – is to buy a coin at a low price and sell at a higher price later. However, this can only be done in a bull market, or when the market is trending upwards. Shorting is a way to profit from a bear market, or when the market is in a downtrend. The easiest way to ‘short’ is for you to borrow a security from a third party (an exchange or broker) and sell it immediately in the market since you expect prices to fall. You can re-enter the market once prices have fallen and buy back the same amount of securities that you initially sold. Thereby settling your account with the third parties. In this case, you will profit from selling the securities initially and buying them back at lower prices.

An easier way to short is by using derivatives contract since it is much cheaper and ‘capital efficient’. If anyone thinks that the prices of a cryptocurrency is unsustainable or would be experiencing a downtrend soon, they could sell derivative contracts in the open market to anyone who thinks otherwise (that the market is going to go upwards).

Read more: Crypto Beginners Guide: 5 Things Crypto Newbies Should Know)

Spot Market vs Derivatives Market

There are generally two kinds of markets in the cryptocurrency world; the spot market and the derivatives market. Both have their own unique characteristics, which can be shown here:

The spot market (or the ‘cash’ market) refers to the exchange and settlement of financial assets – such as stocks and cryptocurrencies – immediately. This means that the ownership of cryptocurrencies is immediately transferred between market participants (from a seller to a buyer) instantly after the transactions are executed. When you go to an exchange to purchase any cryptocurrency, you are participating in the spot market since the transaction occurs on the ’spot’ and you will own the coins that you purchased immediately.

The derivatives market is where participants trade contracts instead of the actual asset itself. These contracts possess value, which is directly tied to the underlying asset. Therefore, derivatives are financial instruments rather than an asset.

(See more: Evolution of Cryptocurrency: Replacing Modern Cash)

Where to Trade Crypto Derivatives

LedgerX was the first regulated institutional exchange that introduced Bitcoin derivatives, in the form of swaps and options. Only accredited investors and institutional players can trade on LedgerX’s trading platform.

Bitcoin futures were first introduced by Chicago Mercantile Exchange (CME) and Chicago Board OptionsExchange (CBOE) on December 2017. Chicago Mercantile Exchange (CME) is the world’s largest derivatives exchange, handling over 20% of the total derivative trading volume globally. Retail investors who are keen to trade CME’s Bitcoin futures can do so via an associated vendor or broker listed here. The differences between CME and CBOE derivatives are shown below:

In terms of derivatives offered by pure cryptocurrency exchanges, Bitmex, OKEX and CryptoFacilities are the current major players. It is important to note that the derivatives product offered by pure cryptocurrency exchanges are not regulated by any jurisdiction at this moment. This increases the risks associated with those derivatives. Here is a comparison between cryptocurrency exchanges that offer derivatives:

Bakkt is a highly-anticipated cryptocurrency futures exchange that is backed by Intercontinental Exchange (ICE), which is the 3rd largest exchange group in the world, behind CME and Hong Kong Exchange. Not only is Bakkt owned by the parent company of the New York Stock Exchange (NYSE), Bakkt is supported by various heavyweights such as Microsoft, Starbucks and Pantera Capital. Bakkt aims to offer Bitcoin futures by January 2019.

Another major player aiming to enter the derivatives space is Nasdaq, the world’s second largest stock exchange. Nasdaq plans to roll out its Bitcoin futures by the first quarter of 2019.

(Read also: Crypto Trading Guide: 4 Common Pitfalls Every Crypto Trader Will Experience)

Word of Caution

Although derivatives was one of the core factors that contributed to the global financial crisis back in 2007, it is still a vital tool in managing investment risks. The market has been extremely excited for cryptocurrency-based derivatives product since major traditional exchanges – CBOE and CME – launched Bitcoin futures at the end of 2017. It is easy to see that the derivatives market is needed for a vibrant financial ecosystem, and perhaps this is the bridge that is needed to enhance the awareness of cryptocurrencies to the mass market. However, caution must be exercised when dealing with derivatives given their complexity and sophistication.

The next article will dive deeper into the technical details of how derivatives actually work and the implications of using these complex financial products.

(You might also be interested in: Evolution of Cryptocurrency: The Problem With Money Today)

Beneficial Resources To Get You Started

If you're starting your journey into the complex world of cryptocurrencies, here's a list of useful resources and guides that will get you on your way:

Trading & Exchange

Wallets

Read also: Guide on Privacy Coins: Comparison of Anonymous Cryptocurrencies and Guide To Cryptocurrency Trading Basics: Do Charts & Technical Analysis Really Work?

This represents the writer’s personal opinions and does not – in any way- constitute a recommendation of an investment or financial advice. Please assume caution when investing in cryptocurrencies and do so at your own risk, as it is extremely volatile and you can lose your money.

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