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The Crypto Derivatives Explained: Meaning & Trading Best Practices

It’s not possible to discuss the rapid growth of the global financial market today without apportioning some credits to cryptocurrencies as one of the major drivers of the financial market. The financial industry has always been very profitable and huge even before the invention of cryptocurrencies which undoubtedly added a feather to the badge of the financial markets.

Traditional financial instruments like stocks and bonds are popularly traded on the financial market. The invention of cryptocurrency included crypto assets as tradable assets on the financial market and in this new evolution are crypto derivatives.

Crypto derivatives are a set of popular financial instruments traded on the financial trading market.

Crypto derivatives are not the same as cryptocurrencies, they are called “derivatives’ because they derive their values from some main elementary asset (cryptocurrencies or tokens). Also, trading crypto derivatives is more seamless and flexible than trading traditional financial instruments like bonds for this reason. With over 40 exchanges trading crypto derivatives and more than 400 global cryptocurrency exchanges, it is evident that cryptocurrencies and crypto derivatives are more globally accessible.

To further analyze their growth performance, crypto derivatives traded on centralized exchange increased to $3.12 trillion in July 2022, indicating a monthly increase of 13%.

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This development, together with the flexibility and management of this crypto financial instrument has pushed many investors and traders to shift their attention toward crypto derivatives. 

However, investing, trading or experimenting with crypto derivatives requires a mastery of the concept. Investors or traders need to know what crypto derivates are, how they work and why they need to build a portfolio around them.

All the information you may need on crypto derivatives is well articulated in this article.

What Are Crypto Derivatives?

Generally, derivatives are referred to as financial contracts between two or more parties venturing into trading a product on a predetermined price. However, the future price of such a product  depends on market instabilities and some other changes.

Traders and merchants use derivatives as a financial tool to serve as a security against a fundamental asset with a fixed price. 

Numerous things can be derivatives; bonds, stocks, interest rates and cryptocurrencies.

Having this in mind, what can be defined as crypto derivatives?

Cryptocurrency derivatives are also financial contracts between two or more parties on a financial asset and a fixed price. In this case, the fundamental assets leveraged as crypto derivatives are mainly cryptocurrency tokens whose future prices are speculated on by the parties involved in the financial contract.

The first and main stage of the contract involves an agreement between both parties on a particular trading price for the cryptocurrency in the future, regardless of its market price at that time.

This means that investors can gain from this agreement as a result of potential price changes of the underlying asset after buying cheap and selling high.

How Crypto Derivatives Are Traded?

Crypto derivatives are simply traded by placing a buy or sell  trade order as inspired by the intuition of the trader as regards where the crypto asset price will hit.

The trader will have the chance to make a profit if his intuition and decision were right but losses will be unavoidable if he makes the wrong decision.

While trading crypto derivatives, traders have the power of making more potential profits or losses in any trading position, through the use of ‘leverage’. This can also be called ‘margin trading’ and allows traders to place trades more than their available balance.

There are many different forms of derivatives but the more popular structures which traders use are listed below;

The most popular type of derivative is future contracts.

Future contracts offers buyers the liberty to buy and sellers, the right to sell an asset at a fixed price at an agreed future date. Even though most traders terminate their futures contracts before the agreed time after making either profits or losses,  futures contracts are used mainly to hedge other investments, especially when the market is a volatile one like crypto market.

Options, as a form of crypto derivative, give traders the option of buying or selling an asset at a fixed price in the future. However, in this form of derivative, the trader is not mandated to exercise his right to take action, hence, the trader has only limited option of either buying and selling at a price and time.  

Investors have no leverage to choose whether to buy or sell in options trading but they can “call” and “put” options.

A call option means the investor can purchase an asset and the put option gives him the right to sell. 

Forwards are another type of crypto derivative which is quite similar to futures contracts but the main difference is that forward contract deals with over-the-counter trade exchanges instead of centralized exchanges. 

Since this trade is done on over-the-counter exchanges, interested parties can customize their trading contracts. However, traders should understand that trading forwards is riskier than other derivative formats due to the lack of centralization.

The good news here is that the parties involved can customize their own trade contracts. Though this flexibility may be appealing, traders should understand that trading forwards is more risky than other derivative structures when there centralization is lacking

Advantages Of Crypto Derivatives 

If you need a reason to trade crypto derivatives, then below are the pros of crypto derivatives which make traders interested in them.

1. Low Cost of Transaction: 

Since derivatives contracts are risk management instruments, they help in reducing market transaction costs. 

It is worthy to note that the transaction costs of trading derivatives are cheaper than other securities like spot trading.

2. Portfolio Diversification: 

Traders can lay their hands on more options to diversify their investment portfolios when trading crypto derivatives. 

They can easily expand their portfolios across multiple crypto assets and also learn some advanced trading strategies like pairs trading, arbitrage etc

3. Liquidity:

An increase in liquidity is an indicator of the large presence of traders in the market.

The nature of crypto derivatives attracts a large pool of professional and institutional traders whose trading power contributes to the liquidity of the crypto market.

4. Risk Management: 

The main reason why many traders trade derivatives are to control risks. Given that the use of derivative contracts is linked to their fundamental assets, traders use derivatives to manage the risks that may be incurred from the price fluctuation of those assets. 

5. Market Efficiency: 

Trading derivatives ensure the market gets to equilibrium through arbitrage. This also ensures that the prices of underlying assets are accurate.

  Disadvantages Of Crypto Derivatives

There are also some drawbacks in the usage and trading of crypto derivatives and they are;

1. High Risk: 

Even though derivatives are used to mitigate the risks involved in trading the underlying assets, it is not entirely free from risk.

Just like the underlying crypto assets are volatile, crypto derivatives  are also largely volatile due to unforeseen fluctuations in the value of their crypto tokens. Sometimes, traders fall at risk of making losses.

2. Speculative in Nature: 

Many see derivative contracts as speculative instrument given that it deals with the predictions of the trader.

However, due to their volatility in prices and the risks involved, such investments can yield  some unexpected losses.

3. Regulatory/Legal Issues: 

A major issue of derivatives contracts is legal sanctions on the activities of derivative traders.

Even though some territories like the US only regulate crypto derivatives trading, it is illegal to engage in derivative trading in some countries.

In 2020, the UK placed a ban on the sale of crypto derivatives to retail investors. 

Conclusion 

In summary, crypto derivatives offer crypto investors a good opportunity to diversify their portfolios and earn extra income. However, it is only useful when a trader deeply understands the market.

Given the various forms of derivatives which have their requirements and conditions, a trader can choose to venture into any that appeals best to him.

 

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