TL: DR

• Crypto derivatives are financial instruments or secondary contracts whose value is derived from a primary underlying crypto asset such as Bitcoin, Ethereum, and others.

• Crypto futures, crypto options, and perpetual contracts are the most popular crypto derivatives.

• The most significant advantage of crypto derivatives is that they allow traders to take on more exposure (i.e., potential gain or risk) to the underlying crypto asset than they currently own. It is critical to guide against the dangers of excessive leverage.

• Crypto derivatives also enable the execution of more complex strategies when compared to spot margin trading.

Introduction

Derivatives are becoming increasingly popular as a tool to help traders manage risk. According to a report on crypto derivative volumes, the derivative market reached 69% of total crypto volumes in July 2022 with a valuation of $4.51 trillion. At the same time, Derivatives are capital-efficient trading instruments that derive their value from other assets, such as Bitcoin or other leading cryptocurrencies like Ethereum. Traders can gain a competitive advantage in risk management while increasing their revenue using derivatives.

Crypto derivatives arose to mitigate the volatility risk associated with crypto. They aim to reduce an investor's risk exposure while also assisting them in protecting their asset portfolios from losses. They are now one of the most critical tools for crypto traders to use when speculating on the price of cryptocurrencies. Therefore, it is crucial to understand what derivatives are and how derivatives trading systems work from the outset.

What are Crypto Derivatives?

Derivatives are well-known products in the financial market even before the advent of cryptocurrencies. For example, you can predict the price of oil dropping in a few months and buy a futures contract using traditional derivatives. Instead of purchasing large quantities of oil, you benefit from the price movement you predicted. Hence, derivatives are financial products, which can be either contracts or securities, that rely on another asset for their value. Currency, bonds, and commodities are the most common underlying assets from which derivatives gain recognition. Derivatives have no value on their own; their worth is determined by the expected price movements of the assets in play.

In recent years, numerous methods for making money with cryptocurrencies have existed. Earning money through crypto derivatives is one of the most popular methods.

Crypto derivatives allow you to make money by predicting whether the value of an asset will rise or fall. Investors who want to protect themselves from price fluctuations prefer crypto derivatives over the primary currency.

How Do Crypto Derivatives work?

Assume you want to physically buy some gold bars and sell them when prices rise. This approach is both too rigid and expensive because of storage and transportation costs. Instead, a better strategy would be to trade an instrument or contract whose price is indexed to gold. These contracts are agreements that allow you to sign with a third party. It also helps you imagine that the price will rise while someone else thinks it will fall.

You and another speculator can sign an agreement stating that if the price moves in any direction after a certain period, one party must pay the price difference to the other.

For example, suppose the price of BTC is $5000, and you believe it will rise. Your counterparty thinks it will fall. However, by the time you need to settle the contract, the price has increased to $7,000.00. The opposing trader will only pay you the $2,000 difference.

Assume the opposite occurs, and the price falls to $3,000; you will be required to pay $2,000. As seen in such a transaction or contract, an investor or trader can profit even when prices fall without owning the underlying asset.

While this is how derivatives work in the context of trading, there are numerous variations in reality. Futures, settlement options, and perpetual contracts are the most widely used derivatives in the cryptocurrency industry. Therefore, we must look at some common types of crypto derivatives.

Types of Crypto Derivatives

1. Futures

This is an agreement between a buyer and a seller to trade an asset in the future. It involves a bet between two parties on the future value of a specific asset at a specified time. This is the one that expert investors use the most because the data from here is helpful in forecasting price movements.

1. Options

Traders can transact a specific cryptocurrency using a future price target and a specified price in crypto options. The distinguishing factor here is that the buyer has the opportunity to opt-out of future purchases of such assets before the expiry date. In addition, the buyer commits to the seller in the form of a premium. Crypto options are classified based on how they are exercised, the currencies quoted, and how they are settled.

1. Perpetual Contract

Perpetual futures are a popular cryptocurrency among day traders. It is similar to futures, except that a trader can hold perpetual futures indefinitely. It has no time limit. A trader's only commitment is to pay a fee to keep the contract alive. This fee is known as the funding rate. Sellers pay funding rates to keep their positions open for as long as the trader wants, with at least a basic amount in the account known as a margin.

How to Choose the Suitable Crypto Derivatives

When determining the crypto derivative to invest in, remember some essential points. These points include:

1. Safe and secure Exchange

There are two types of exchanges: spot and derivatives exchanges.

The spot exchange makes the settlement of crypto assets immediately, either fiat to crypto or the other way around. Cryptocurrencies are transferred directly between sellers and buyers.

On the other hand, a derivatives exchange facilitates the trading of derivative products such as futures and options. Selecting a safe and secure exchange such as gate.io to trade your crypto derivatives is the first key factor toward making the right choice. Your funds, assets, and personal data are always at risk if the Exchange you choose for crypto derivatives trading lacks adequate safeguards.

2. Insurance funds

It is also pertinent you ensure there are safety nets that protect traders from unforeseen losses when choosing crypto derivatives. Traders do not need to bother about socialized losses when using a well-capitalized insurance fund because the Exchange will cover the deficit. Certain exchanges may run multiple insurance funds to ensure that losses are adequately protected during high-volume spikes.

3. Infrastructure and technology

Another crucial factor is the crypto derivatives' infrastructure and technology. A high-performance matching engine provides the infrastructure to efficiently and at scale roll out new order types and trading pairs, creating a better product for all users. Your trading experiences and ability to transact efficiently are influenced by technology and infrastructure.

4. Fee

Transaction costs are a significant component of derivatives trading, mainly if you are an active trader. Understanding the various fee structures used by derivative exchanges can help you save a considerable amount of money.

5. Liquidity and Volume

Traders rely on market liquidity and volume because they influence transaction costs. A seller in a liquid market will quickly find a buyer without lowering the asset's price to make it more appealing. On the other hand, buyers will not have to pay more to secure the investment they desire.

A less volatile market is also associated with lower risk. A counterparty is usually willing to take the other side of a given position. This can draw speculators and investors to the market, adding to the already favorable market conditions.

6. Define your risk appetite

Trading crypto derivatives come with risks that may require you to establish your risk appetite. Establishing your risk appetite will enable you to determine whether a crypto derivative falls within your risk tolerance. Things to consider in determining your risk appetite include financial capability, investment timeline, and emotional capacity.

7. Do your research

It is critical to conduct your own research in the derivative market. However, keep in mind that the strategies must differ from those used in the spot market.

Importance of Crypto Derivatives

1. Alternative to holding physical assets: Crypto derivatives save market participants the stress of navigating wallets and other complicated market infrastructures by not having the physical asset.

2. A safer way to gain access to asset class: For new buy-side participants, dealing with regulated counterparties through crypto derivatives is a safer way to gain access to the asset class.

3. Increasing liquidity: Crypto derivatives improve market liquidity by making it easier for traders to open and close positions. There is usually less risk in a liquid market because someone is always willing to take the other side of a position.

4. Mitigating risk: A robust derivatives market aids in attracting professional traders and institutional investors to the cryptocurrency industry by mitigating the threat posed by a portfolio's exposure to tail-risk events.

5. Portfolio Diversification: Derivatives provide more ways to diversify your investment portfolios. You can trade multiple cryptocurrencies, and master advanced trading strategies through crypto derivatives.

Hedging & Speculation

There are two ultimate goals in crypto derivative trading: hedging and speculation.

1. Hedging: Hedging is a position taken to safeguard a cryptocurrency portfolio against market volatility. Positions are opened in the opposite direction of the spot position. By this, any profit or loss in one part is offset by changes in the value of the other.

For example, futures can help protect investments without jeopardizing current crypto holdings. This protection is because futures allow you to hedge a portfolio for a fraction of the cost. For example, if you have a $50,000 portfolio, you can hedge it by opening a short position in a futures contract. A 10x contract will only cost you $5,000, or one-tenth of the market value of your portfolio.

Hedging is especially useful when crypto enters a bear market because it is far preferable to waiting for the price to recover or liquidating holdings at an unfavorable price.

2. Speculation: Speculation entails purchasing a token when you believe it is oversold, holding it until it appreciates, and selling it once it has recovered. A trader can use derivatives to speculate on both ends of the market. You can use leverage to maximize your profit if you believe a crypto asset will rise in value. Similarly, even if the market is falling, you can still profit from it. For instance, if you buy Bitcoin, you can benefit if the price rises. However, in a bear market, you cannot profit from this principle because prices constantly fall.

Futures contracts come into play here. They allow you to wager that prices will fall (going short). If the price of Bitcoin falls, your short position means you're profiting even during a bear market. Futures contracts enable you to trade, profit from market volatility, and seize opportunities by going long or short.

Conclusion

With the rapid growth in the cryptocurrency space comes a variety of products. Some of them, such as options, may require complex strategies, whereas others, such as futures, require only basic trading knowledge and a good risk management strategy. In anyways, you must apply the tips on choosing suitable crypto derivatives to avoid losses and maximize profits.

Author: Gate.io Observer: M. Olatunji

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* This article represents only the views of the observers and does not constitute any investment suggestions.

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