The future of cryptocurrencies stands beyond worldwide transactions and deployed applications. Therefore, more opportunities for developing products have arisen from users’ willingness to create better networks. Nowadays, if you want to know the best way to buy Bitcoin, you go on platforms such as Binance to get the latest updates and favorable circumstances. Another example of how rapidly these products grow is crypto derivatives, which depend on the crypto market’s development.
The derivative market increased considerably in 2022, especially smart contracts, which have proven to be one of the best tools for developing, coding and deploying on blockchain networks. However, many other crypto derivatives rule the market, and we’ll discuss their importance since they’re part of a rising trend.
What are crypto derivatives?
In general, derivatives include tradable financial instruments of which value comes from another asset, in this case, cryptocurrency. More traders prefer them because derivatives allow for price movement exposure without them having to own them. Since these instruments are primarily used for hedging and speculating, they’re suitable for advanced professionals. Derivatives have become an essential part of a trader’s portfolio, and there are two common types unique to the market.
The first type of derivative is futures, which is basically a contract between buyers and sellers. Their agreements are usually made to buy or sell cryptocurrency at a set price for a certain future period. After the contract expires, the buyer must purchase and receive the cryptocurrency, while the seller must sell and transfer it. Futures can be used as a form of strategy for:
- Entering a long position or buying. This is usually done when the price of an asset at the moment is higher than the future price set by one of the involved parties;
- Entering a short position or selling. This happens when the crypto price is lower than the price set but only at the expiry date;
The second type of derivatives is called options, and it works by allowing the crypto holder the rights, but not the obligations, to buy or sell an asset, with the same rules as previously discussed. Depending on the trader’s goal, options can be:
- Long call, when the holder has the right to buy the asset at any time until the expiry date;
- Long put, when the holder has the right to sell until the expiry date;
- Short call, when a call option is sold obligately;
- Short put, when a call option is bought obligately;
Depending on where the current crypto price is compared to the strike price, options can be in-the-money (ITM) or at-the-money (ATM). However, if you want to get even more in-depth in derivatives trading, there are also perpetual contracts, which are the equivalent of CFD (contracted for difference). The difference between perpetual contracts and other types of derivatives is that here we don’t have the concept of an expiry date. As a trader, you can keep your position for as long as you want, but your account must hold a minimum amount of crypto.
What can you use derivatives for?
Usually, derivatives are used for hedging and speculating. Hedging is a strategy used to reduce loss risk. For example, when a trader buys crypto with the intent for the price to rise, the trader can minimize the potential losses in case the price drops. On the other hand, speculating is more on the betting side, where traders have to guess if the prices will increase or decrease, so they enter a long or short position to make a profit. In this case, wins or losses can be substantially amplified, so this is a high-risk strategy.
Why are derivatives important?
Crypto derivatives are essential for the market because they offer a much broader opportunity for a trader to diversify their investment portfolios. They’re recognized as an asset class, which makes them essential for the community. However, what makes them special includes the following:
- They increase liquidity by making it easier for traders to open or close positions. For example, when the market is liquid, there’s less risk since anyone can take the other side of a position, which can be beneficial for perpetual contracts, for example;
- They help mitigate risks because they attract professional traders and institutional investors within the market. At the same time, derivatives can predict risky investments, for example, when asset prices are overbought;
- They help diversify your portfolio since they can expand across multiple industries, such as arbitrage, pairs trading and short-selling. Moreover, the market can become more liquid if traders approach more advanced strategies;
- They optimize price discovery by allowing investors to go long or short, which leads to smoother market adjustments, and price shocks can be avoided. Therefore, price reliability is improved, and the market becomes more efficient;
Are there disadvantages to using derivatives?
The crypto market is known for presenting certain disadvantages. So, derivatives have the following downsides:
- They hold a high risk because the value of underlying assets often fluctuates, which makes these contracts highly volatile, leading to a risk of losses;
- They raise regulatory concerns since derivatives are still not fully legal worldwide, so when trading, the two parties involved must live in an area where derivatives are allowed;
- They present a lack of due diligence because traders can’t correctly check the other side of the transaction since these contracts don’t always stick to compliance procedures;
However, derivatives also present the following advantages:
- They’re efficient on the market because derivatives ensure the crypto market prices are accurate;
- They have low transaction costs due to being effective risk management tools;
- They help mitigate risks since they’re tied to underlying assets;
- They have higher leverage which allows traders to increase profit margins;
- They have high liquidity due to the high demand;
- They minimize portfolio risks and increase diversification opportunities;
Crypto derivatives are unique assets on the market, and their importance is increased due to the rise of professional traders and investors. They can be highly beneficial for the market but lack regulatory concerns at the moment, so approaching derivatives must be done only by advanced traders.