What are Derivatives and Who Should be Trading Them?
A derivative is a financial contract between two or more parties that derives its value from a particular asset. Derivatives contracts can represent almost anything (commodities, forex pairs or even cryptocurrency) and they are useful because you can trade the underlying asset without directly buying it or handling it.
A Brief History of Derivatives
Derivatives have existed for thousands of years, but it was only in the 1980s during a period of financial deregulation that the market for these contracts exploded in value.
The annual volume of derivative contracts traded on exchanges like the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX) was around 20 million in the early 1970s, but this figure rapidly increased to over 200 million by 1990.
As the market for these contracts proliferated in the 1990s and 2000s, more complicated derivatives than the relatively simple futures and options contracts became more widely used by bank’s to reduce their operational risk. Some examples of these complex derivatives include credit default swaps, exotic options and structured products.
Derivatives are beneficial in that they bring liquidity to markets by attracting investors who take on risks that most other individuals do not want to bear. The increased liquidity provided by market participants contributes to lower price volatility and a reduced spread between the bid prices and ask prices for an asset.
By 2011, the trading of bitcoin (BTC) had started to grow popular and the first cryptocurrency derivatives exchanges started to appear such as ICBIT and Bitoption (and then later 1Broker).
Traditional exchanges, such as the Chicago Board Options Exchange (CBOE) and the CME, finally started to take notice of bitcoin in December 2017 and introduced their own futures contracts.
Check out our post on the evolution of bitcoin derivatives here.
Other types of derivatives include options and perpetual swaps, both of which are becoming increasingly used in the cryptocurrency market:
- Futures are contracts used to bet on the future price of an asset or as a hedging mechanism. Futures contracts have an expiry date at which the contract is settled, leading to a difference between the underlying and futures price called the basis.
- Options are more complicated and give the party the right, but not the obligation, to buy or sell an asset at an agreed price at (or until) a particular date. Put options are used to bet on the price of an asset falling while call options are used to bet on the price of an asset rising. The strike price at the option’s expiry date is used to determine profits and losses. The valuation of the option and the price of the underlying asset have a non-linear relationship.
- Perpetual swaps are like futures contracts but do not have an expiry date or settlement date. These contracts get their name from the fact that they trade in perpetuity and never expire. A further difference between futures and perpetuals is that the funding cost of perpetuals is used to keep the price of the perpetual contract the same as the underlying index, keeping the perpetual more in line with the price of the underlying asset.
How are Derivatives Used?
The three main reasons traders and financial institutions use derivatives are:
- to hedge an existing position,
- for arbitrage opportunities, and
- to speculate on the price without trading the underlying asset.
1. To Hedge an Existing Position
Suppose an investor holds 3 BTC as a store of value. They can hedge their bitcoin exposure by selling a derivatives contract with a value of anything up to 3 BTC to offset any losses (or gains). Using derivatives to hedge is useful in bear markets when the price of bitcoin is falling to protect the investor’s fiat balance.
If a trader sells BTC-PERP contracts on Interdax and the value of bitcoin declines rapidly, they would have limited their downside. While the dollar value of 3 BTC has fallen, the short position using a bitcoin futures contract or perpetual swap offsets the loss.
You could use 1:1 leverage for a short position as a hedge if you want to reduce your cryptocurrency exposure and it is equivalent to selling for USD. When hedging with derivatives, you do not need to sell your crypto-assets to eliminate or reduce your exposure.
2. For Arbitrage Opportunities
Derivatives contracts can also be used to take advantage of price differences in an asset across different exchanges to generate risk-free profit (known as arbitrage). While arbitrage is possible in the cryptocurrency market, it is not easy and often requires a lot of work.
For instance, cross-border arbitrage is probably the most obvious form in cryptocurrency markets, where local exchanges in two countries offer different prices for BTC. To arbitrage in this case, you would need access to banking services in both countries. But the simplest form of arbitrage is to buy an asset on one exchange and sell it on another exchange that has a higher price.
Suppose one bitcoin at a spot exchange costs $9,900 while another exchange offers a bitcoin derivative at $10,000. You can then generate an almost instant, risk-free profit by buying 1 BTC on the spot exchange, send 1 BTC to the other exchange and sell 1 BTC for $10,000. You profit without taking on any risk, and your gains per BTC would be equal to $100 (minus any fees).
To find arbitrage opportunities across cryptocurrency exchanges, traders can use scripts, bots or other automated methods. Although arbitrage opportunities can generate smaller, more consistent profits, leveraged trading can result in larger (but more inconsistent) profits.
3. To Speculate on the Price without Trading the Underlying Asset
Derivatives can be used to speculate on future price movements without having to purchase the actual asset.
Let’s say we have an investor who wants to trade bitcoin but only has limited knowledge of cold storage. They want to gain exposure to the cryptocurrency’s price fluctuations over the long term — but they do not want to purchase bitcoin and take on the risk of securing it.
Instead, the investor can buy futures contracts to go long on bitcoin without having to worry about securing the number of coins that make up their position.
For instance, the investor could buy 100 futures contracts to gain exposure to bitcoin’s price fluctuations, which makes his position size amount to 500 BTC. Suppose the price is $8,000 and the expiry is the end of January 2020.
If the price increases to $10,000 by the end of January 2020, then the investor will be in profit. The futures contract says he can claim 500 bitcoins for a price of $8,000 and he can sell these coins for $10,000 each on the spot market once the futures contract is settled.
Market participants can also use derivatives to enter leveraged positions to amplify the profits (and losses) of their trades. Leveraged positions are larger than the value of the coins in your trading account.
For example, if a trader holds 1 BTC and expects an upward move in the price, they can use Interdax’s bitcoin perpetual swap (BTC-PERP) to enter a leveraged long position.
By using 10:1 leverage, the trader can enter a position size of up to approximately 10 BTC (using just 1 BTC as collateral). They can potentially multiply their potential profits (or losses) by a factor of 10 as compared to a position size of just 1 BTC.
Who Should be Trading Derivatives?
A strong understanding of markets and trading are a prerequisite. If you cannot trade profitably in spot markets, then you are probably not ready to trade derivatives.
It is essential to acquire a good knowledge of technical analysis, fundamental analysis and risk management before trading derivatives.
Simple derivative contracts are not inherently risky; their risk lies in the user not understanding how derivatives work and how to use them with leverage.
If you haven’t used derivatives before but feel you are ready, start with a low leverage of 2:1 or 3:1 to become familiar with trading these contracts. You should also review any documentation before trading so that you are aware of the mechanics behind the contract and how it functions. As you build experience (and increase the size of your trading account), you can progressively increase your leverage.
Check out our risk management guide in the Interdax Help Centre before you start trading bitcoin derivatives.
There are various groups and individuals who trade derivatives including:
- Bitcoin-accepting businesses or miners can benefit from futures or perpetual swaps as they can lock in a price for any bitcoins they produce/hold and hedge against price volatility.
- Hedge funds and trading firms may also use derivatives to take advantage of leverage, as a hedge against their positions or to enhance their portfolio management.
- Individual traders and investors use derivatives to go short on cryptocurrencies (as well as going long) and may use leverage to boost their profits.
Trading Derivatives on Interdax
Investors can trade bitcoin perpetual contracts on Interdax’s beta platform. The BTC-PERP instrument can be used to hedge existing BTC holdings, arbitrage against other markets or for investors to trade the price fluctuations with up to 100:1 leverage.
To provide a full hedge against 1 BTC (if the price is $10,000), you’ll need to buy around 10,000 contracts. If you are a day trader and you want to enter a position of 10 BTC (and the price is $10,000), you’ll need to buy around 100,000 contracts.
Other features include continuous settlement in bitcoin and a robust index to price the contract. As an inverse contract, BTC-PERP is quoted in USDT but each contract represents 1 USDT worth of bitcoin. Therefore, the position size of 1 contract in terms of BTC is [1/BTCUSDT].
More information about Interdax’s bitcoin perpetual contract can be found here.
In summary, derivatives are financial contracts based on an underlying asset enabling you to place leveraged bets, hedge against price volatility and arbitrage across different markets. To trade derivatives successfully, you should understand the risks involved, have a deep knowledge of the instrument and market you are trading, and apply sensible risk management.
