How are Crypto Derivatives Operational?
Derivatives are financial instruments whose value is derived from an underlying asset. As a result, the value of crypto derivatives comes from cryptocurrencies. They are contracts for money between two parties to speculate on the price of the underlying cryptocurrency in the future.
Therefore, parties to a Futures contract, a type of cryptocurrency derivative, will agree on a selling and buying price for the cryptocurrency in one month, say, regardless of the current price. The buyer may gain if the price of the underlying cryptocurrency rises to a level higher than the agreed-upon price a month later.
The following are examples of crypto derivatives: Contracts for Future and Perpetual Use Additionally, the seller will profit if the price of the underlying cryptocurrency falls below the agreed-upon amount because the buyer will pay more for the asset than the actual market price.
What kinds of cryptocurrency derivatives exist?
There are numerous varieties of crypto derivatives, such as:
- Options
- Swaps
- Futures
- perpetual agreements
These derivatives generally behave differently depending on the conditions. Let’s start with Futures—what is it exactly?
How do Prospects Function?
As the name suggests, it is a legal agreement between two parties to purchase or sell an asset at a predetermined future price. Therefore, the parties typically reach an agreement on two things before entering into the contract. The first is the price at which they will exchange the asset in the future, and the second is the contract’s expiration date, also called the settlement date.
When two traders of crypto derivatives, Mercy and Frank, enter into a futures contract when the price of Bitcoin is $30,000, Mercy is bullish on Bitcoin and believes that it will surpass $30,000 within a month, which is the contract’s expiration date. This is an illustration of how crypto futures work. This indicates that, regardless of how much BTC will cost in a month, she will be required to pay $30,000 for one BTC.
The following are examples of crypto derivatives: Frank, on the other hand, is pessimistic regarding Bitcoin and predicts that the price of the cryptocurrency will fall below $30,000 within the following month. Therefore, Frank interprets the contract as a commitment on his part to sell BTC at the agreed-upon price, irrespective of the asset’s subsequent price.
Okay, let’s take a look at a few different scenarios to see which one is more profitable:
- 1st scenario: If Mercy was correct, the price of Bitcoin could reach, say, $37,000. She will now purchase BTC from Frank at a discount as a result. In this instance, she will make a profit of $7,000 without paying any fees.
- 2nd scenario: Let’s say that Mercy’s prediction was wrong and Bitcoin falls to $25,000 today. Frank will still have to pay her the agreed-upon $300,000 for the BTC, so she will lose $500 and Frank will make $500. There are still nuanced aspects to Futures, but that is how it generally works.
Contracts for Life: Which are they?
Perpetual contracts have no expiration date, in contrast to futures, which have a predetermined date. Investors can therefore maintain their positions for as long as they like. Price pegs, as a result, guarantee that perpetual contracts are traded at prices that are either nearly identical to or identical to the prices of spot markets.
To keep the price in line with the spot market, contract sellers and buyers pay a premium known as a funding payment. As a result, the price remains unchanged.
Learn more about contracts that last forever. Let’s say Mercy decides to invest in perpetual contracts this time when the price of Bitcoin is approximately $30,000. Because she anticipates Bitcoin’s price to rise, she decides to spend $30,000 on a perpetual contract. After two months, the price of Bitcoin does indeed rise to around $40,000.
Mercy, as a result, terminates her employment because she is content with the $10,000 profit. Leverage opportunities are also provided by crypto derivatives like futures and perpetual contracts.
The following are examples of crypto derivatives: You can open a trading position with futures and perpetual contracts that are larger than your trading capital, which is all they mean. As a result, Mercy’s capital and profit will now double if a derivative exchange provides two times the leverage. However, because leverage increases both profits and losses, the risk of liquidation is extremely high.
Let’s quickly look at how Mercy might react to this. But before that, let’s try to break down the concepts of initial margin and maintenance margin. The first one discusses the bare minimum required to establish a leveraged position.
Let’s use the number $30,000 as an illustration. As a result, Mercy will be required to provide collateral for $30,000. To construct a leveraged position with twice the strength. Mercy, on the other hand, can’t keep her trading positions open unless she holds the minimum amount of collateral, called the maintenance margin. If the prices of Bitcoin move against Mercy and her margin balance falls below this level, Mercy may be required to either add additional funds to her account or have her account dissolved.
However, the cryptocurrency’s most frequently traded financial instrument is perpetual. At the time of this video, Perpetuals’ 24-hour volume was over $126 billion, while Futures’ was $5 billion. However, if the price is already correlated with Bitcoin, why not simply hold Bitcoin itself? These derivatives are crucial to risk management in cryptocurrency.
Consider Mercy’s actual Bitcoin, whose value is decreasing. Because she also trades crypto derivatives, she has the option of purchasing a derivative contract whose value fluctuates in opposition to her BTC holdings. She ought to be able to use the gains from the derivatives to compensate for the losses on her actual BTC at this point.
