What Are Crypto Derivatives and How Do They Work?

Cryptocurrency and blockchain technology have revolutionised the tech world, providing an alternative to the traditional financial markets, albeit a highly volatile one. This new, decentralised market is dominated by various kinds of cryptocurrency tokens whose prices constantly move in upward and downward directions based on trends and several other micro factors. Several tools have emerged alongside the crypto market to help traders make better predictions and manage financial risk more efficiently. In this article, we’ll discuss one of these instruments, derivatives, examining how they work and how they benefit traders.

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What Are Crypto Derivatives?

Crypto derivatives are financial instruments whose inherent value lies in an underlying digital asset. In other words, crypto derivatives are financial contracts between two or more parties. While derivatives trading is a popular feature of the cryptocurrency market today, traditional derivatives are a financial instrument with deep roots in human history. The idea of trading contracts that let traders speculate on the direction of an asset’s price movement, making profit or loss as a result, is a concept that is not unique to cryptocurrency. Today, various crypto exchanges offer various derivatives, offering savvy traders a unique opportunity to make solid profits with calculated risk.

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3 Types of Crypto Derivatives

Futures

Crypto futures let traders speculate on the future prices of cryptocurrency assets. With crypto futures, a contract is drawn up between the seller and the buyer to purchase or sell a certain digital asset at a set price and date in the future. For example, an investor banking on an Ethereum bull run in two months may buy a futures contract that lets him sell assets at a high price in the future. However, the investor takes a loss if Ethereum’s price has dropped by the agreed date. To better understand how crypto futures work, it is essential to note that the contracts apply to fixed points in the future and do not consider the asset’s spot price. Rather, it’s a type of bet made on what the investor thinks the asset’s price will be when the contract expires.

Perpetual Futures

Perpetual futures are similar to traditional futures in that the contracts deal with the future price movements of assets. However, this type of derivative is best suited to traders comfortable with continuously trading a futures contract that never expires. With perpetual futures, the contracts are open indefinitely, except the trader decides to close their trading position. This is an especially efficient tactic for investors who want to profit significantly from long-term price movements in the underlying crypto asset.

Options

This type of crypto derivative allows contract holders the option to purchase or sell crypto assets at fixed prices. They differ from futures because the investors are not compelled to purchase or sell the assets. With options, investors can hedge against potential price fluctuations. Nevertheless, trading options derivatives involves multiple fees depending on the broker, including commission, margin interest, contract and exercise fees.

Benefits of Crypto Derivatives

The main advantage of trading crypto derivatives is the cost relative to regular spot trading. In addition, it is a great way to hedge against price fluctuations and limit the damage incurred in the event of a loss. With derivatives, traders can control significant positions with relatively small capital, all with the potential for maximum gains. It is also a way to help investors speculate, predict future crypto prices and trade more flexibly than with conventional financial instruments.

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Conclusion

Crypto derivatives provide a great trading opportunity for investors, helping to mitigate the risks of damaging losses. Nevertheless, it can be tricky for newbie investors to navigate while the legal status of derivatives in certain countries is unclear. Regardless, crypto derivatives can be expected to evolve along with other components of decentralised finance. 

Frequently Asked Questions

Is It Easy to Trade Crypto Derivatives?

Derivatives trading is quite complex, as there’s no set template for success. It is common for traders to use various strategies depending on their risk tolerance and predominant market sentiment.

Should You Trade Crypto Derivatives?

The decision to trade crypto derivatives should not be devoid of knowledge of the types of derivatives available and the risks involved.

Is Crypto Derivatives Trading Legal?

Many countries presently don’t have laws governing crypto derivatives, which can lead to market manipulation and fraud issues.