What are derivatives?
A derivative is an economic agreement about the future price of a cryptocurrency, security, product, or service. The subject of such a contract is called the underlying asset. Sellers and buyers of derivatives do not own the underlying assets but sell and buy the right to execute the contract.
Why are derivatives needed?
To decrease risks and earn money from price changes. This is true for both traditional and cryptocurrency exchanges. Let us explain this with examples.
If trader John fears that bitcoin will fall in price to $ 3 thousand by next Tuesday, he can agree with trader Bill to sell him bitcoins when the price drops to $ 3.5 thousand. This is how derivatives help mitigate risks.
And if trader George wants to buy bitcoin for $ 3.5 thousand before Tuesday, he can buy a contract from Bill, and then John will sell bitcoins to George. John will receive money from George without waiting for the agreed price. By selling and buying this contract, traders can make money depending on the price of the underlying asset. This is how derivatives are used to make money.
How do you make money on cryptocurrency derivatives?
Traders make prof by changing the price of the underlying asset. Since the future market price of the underlying asset is unknown, all traders assume the risk. If at the time of the execution of the contract the goods have fallen in price, then the seller receives the profit, and the buyer remains at a loss. If the price of the goods has risen, then the buyer remains the winner
To increase earnings, a trader uses leverage - a loan provided by the exchange. The leverage is proportional to the deposit made by the trader. Thanks to this, a trader can make transactions for large amounts. The leverage depends on the exchange. Most exchanges provide leverage with a commission.
Let's say the current price of BTC is about $ 8,000. George believes that it will fall. He enters 1 BTC on the exchange, chooses 10x leverage, and sells 80,000 contracts at $ 8,000 for 1 BTC. Two hours later, the bitcoin price drops to $ 7,600. Then George buys the same contracts and receives on his balance sheet a net profit of 80,000/7600 - 80,000/8000 = 0.52 BTC. Now George has 1.52 BTC on his account.
What are the types of cryptocurrency derivatives?
- Futures
- Forwards
- Options
- Swaps
- CFD (contract for price difference)
What are futures?
Futures is an agreement to sell or buy an underlying asset at an agreed price in the future (hence the name). For example, you order a specific configuration of a car at a car dealership. It will be delivered in six months, and you will be required to buy the car at the agreed price.
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There are also perpetual futures. They do not have a settlement or close date, so they can be bought and sold at any time.
What is a forward?
Forward - an over-the-counter contract for the purchase and sale of goods in the future. It is similar to futures but less standardized. Futures are traded on the exchange and the forward is traded through OTC. For example, you agree to translate a book in the future, and the publisher pledges to pay for the finished work.
Bitcoin Forwards are traded on the TeraExchange, an American regulated exchange.
What is an option?
Option - an agreement that gives the buyer the right, but not the obligation, to buy goods at an agreed price. For example, you ask to hold the goods until tomorrow because you have no money with you.
Deribit and LedgerX provide options to trade options.
What is a swap?
A swap is two contracts: the purchase and sale of the underlying asset and the purchase and sale of the same asset in the future. This is a more complex futures option. For example, you buy a specific configuration of a car, but at the same time agree with a friend that you will sell this car to him at a higher price.
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Perpetual swaps are available on the BitMEX exchange.
What is CFD?
CFD (contract for difference) is a derivative for the price difference of the underlying asset. If during the term of the contract the asset has risen in price, the seller pays the difference. If it has fallen in price, the buyer pays it. Often such contracts are open-ended and are closed by the party who has such a right under the contract. For example, a store promises to refund the difference in price if you find the same item cheaper.
Crypto CFDs are available on the eToro platform.