Derivatives Glossary

Understand what you’re trading

Derivative

Definition

A contract that derives its value from the performance of an underlying asset. Since the derivative contract is a separate financial product, its price can theoretically diverge from the price of underlying asset. This divergence is mitigated with liquidation mechanics: the margin positions are liquidated at mark price, which is calculated from an underlying asset price. This makes it rational for arbitrageurs to keep the prices of derivative & underlying close to each other.

Example

BitMEX XBTUSD perpetual swap is a contract whose value is derived from .BXBT index of BTCUSD prices from 3 exchanges. The price of XBTUSD contract may differ from the price of BTCUSD, but extreme differences are quickly arbitraged away.

Usage

Derivative contracts can be used to build a short position that doesn’t require paying a funding rate.

Derivative contracts can be used to trade volatility (the speed of price movement, not the direction).

Derivative contracts can be used to create different payout strategies (e.g. options become profitable only after certain price is reached).

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Mark price

Definition

A reference price of a derivative that is calculated from underlying index, often calculated as a weighted index spot price of an asset across multiple exchanges (to protect from manipulation on a single exchange).

TL;DR: Real asset price.

Example

BitMEX calculates the mark price of XBTUSD contract using .BXBT index (purple line on the chart):

Mark price = .BXBT index (purple line) + Funding basis rate

Usage

Mark price is used to liquidate margin positions.

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Swap

Definition

A derivative contract in which two parties agree to exchange one stream of cash flows against another stream. These streams can be periodic interest, or dividend payments, or loan returns. So instead of exchanging the interest-yielding assets themselves, the parties exchange the cash flows arising from that interest.

TL;DR: A contract in which parties exchange future dividends of assets instead of assets themselves.

Exchanging the fruits, not the trees

Example

Michael is a miner. His income fluctuates based on the market price of ABC coin that he’s currently mining. He wants to minimize his risk by switching from probabilistic payments to fixed payments.

Ted is a trader. Ted believes that market price of ABC coin is going to increase. However, Ted doesn’t want to install mining equipment. Also, Ted doesn’t want to buy ABC coin on exchange because the orderbook is thin, so he can’t build a large position.

Ted and Michael enter into a swap agreement where Ted provides a fixed monthly payment for Michael in exchange for receiving ABC coin mined with Michael’s equipment (essentially, renting his rig).