What are crypto derivatives?

A crypto derivative, such as a “perpetual futures,” is a financial instrument that “derives” its value from an underlying cryptocurrency or digital asset. For example, there are many perpetual futures contracts based on Bitcoin. Derivatives are contracts between two or more parties. The most common type of derivatives in crypto markets are the aforementioned perpetual futures, with traditional futures and options a distant second and third.

Table of Contents

  1. How do derivatives work?
  2. Centralized or decentralized crypto derivatives?
  3. Risks

How do derivatives work?

There are many kinds of derivatives, but all of them feature a contract between two or more parties to buy or sell an underlying asset at some point in the future. Let’s look at some of the more popular kinds of derivatives:

Futures: A contract that commits two or more parties to buy or sell an asset at a set time in the future at a set price. For example, if you buy an “10AUG2022 BTC” contract at US$20,000, it means you agree to buy one contract worth of Bitcoin on August 10, 2022 for 20,000 US dollars. If the price is above US$20,000 you effectively make money, but the reverse is true if it’s below. Since futures contract are for a specific point in the future, the price of the contract does not necessarily track closely to the underlying asset’s spot price. Instead, it will trade at what people think the price will be at the time of expiry.

Perpetual futures: Perpetual futures, or “perps,” are a special type of futures contract. As the name implies, perps do not have an expiry date. These contracts can be held perpetually. Since the contracts can be held indefinitely, the price of the contract trades very close to the spot price.

Options: Unlike with futures contracts, where the contract commits the parties to buy or sell an asset, options gives the buyer the right, but not the obligation to buy or sell the asset by a certain date at a specified price. The seller of an option is still committed to buy or sell the underlying asset. Option sellers charge a fee, or premium, for the option contract.

Centralized or decentralized crypto derivatives?

In crypto’s short history, the most popular place to trade derivatives has been on centralized exchanges. These exchanges provided liquidity and a responsive trading environment, both of which are important for shorter time frame derivatives trading. A major drawback has been many allegations that centralized exchanges have abused their privileged place of information to actively trade against their customers. Also, during major market events, centralized exchanges have been apt to go offline, causing customers with open positions to be liquidated.

This is slowly changing as DeFi matures. Now there are a handful of viable decentralized derivatives platforms. They still lack the liquidity depth and responsiveness of centralized exchanges, but those differences will likely narrow over time.

Risks

Derivative trading is a much riskier endeavor than simply owning the underlying asset. Derivatives are by their nature more volatile than the underlying asset. Crypto is already a very volatile asset class, so derivatives are even more so. Derivatives also allow leverage, which increases risks even further.

For these reasons, it is not recommended for new or even intermediate traders to use derivatives. If you are new to derivatives and you wish to learn, do not use leverage.

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