Cryptocurrency Markets Need Derivatives
Derivatives provide the ability to both speculate and, even more importantly in this turbulent and volatile market, hedge
Derivatives are financial instruments that derive their value from some other financial asset/variable — termed an underlying asset. There are many types of derivatives being traded on the traditional markets presently, but to give you a broad idea of what kind of financial instruments derivatives are, I’ll briefly explain the most commonly-traded ones: futures, swaps, options, & warrants.
A futures contract is a standardized financial contract obliging one party to pay the other a predetermined sum of money for an underlying asset at a specific point in time in the future.
Swaps, like futures, are also standardized financial contracts but used for something else entirely; through swaps, parties exchange financial instruments such as assets or liabilities at a predetermined time specified in the swap contract, without having to liquidate the instruments traded.
Options and warrants are contracts that give one of the contractual parties (the option holder) the right, but not the obligation to buy or sell the underlying asset of the contract at a specific time in the future.
Derivatives are of immense benefit to markets. After all the controversies surrounding ICOs (including outright scams), the cryptosphere is in dire need of some legitimacy — and the introduction of derivatives helps do just that. Crypto derivatives enhance exposure and attract large professional investors and institutions to the crypto market, while also putting pressure on regulators to act fast and deliver legislation. Legislation fills regulatory gaps and enhances investor protection and legal certainty in the crypto industry.
But what do crypto derivatives mean for investors and why should you trade in them?
Think of derivatives as predictions in the form of a contract between two parties about the future development of an underlying asset. Often they’re used as speculative instruments, but another critical role they play is to serve as an insurance against price fluctuation losses (a.k.a hedging.) In extremely volatile markets such as cryptocurrency, hedging with derivatives can protect against unfavorable price fluctuations like the sharp downturn we’ve seen in recent weeks.
Derivatives contracts serve investors and allow them to profit from price fluctuations without having to own the underlying cryptocurrency and incur all the risks associated with it.
Let’s look at this from a practical perspective:
Let’s say Alice want to speculate on Bitcoin. There are two types of options:
- Call option: gives Alice the option to buy BTC at a set price in the future
- Put option: gives Alice the option to sell BTC at a set price in the future
Option contracts have a price (a.k.a the premium), which is what she needs to pay for the opportunity to execute that trade. On the other side of the trade is Bob, and he is said to write the contract that Alice buys. For simplicity’s sake, let’s leave Bob out of this one.
At the time of writing the market price of bitcoin is ~$4,500 and Alice believes the price will go up to $6000 in a specific time in the not so distant future.
A call option contract gives her the opportunity to buy one bitcoin at $5,500 on a specific date; if bitcoin’s price goes up to $6000 by that time, Alice can buy that bitcoin for $5,500 and make $500 profit by selling it immediately, or she can wait and buy Bitcoin at an even higher price and execute an even more profitable trade.
Markets today are turbulent, though. So Alice also wants some insurance in the event her predictions are incorrect. She can also buy a put option contract that hedges her forecast of prices moving up. If prices do in fact increase, she simply does not execute the put and therefore only pays the premium on the contract — a small price to pay for piece of mind.
As our CEO, Joshua Greenwald, puts it:
“Options facilitate not only the ability to take short positions in cryptoassets, but to express nuanced opinions on the shape of things to come.”
Although there is a myriad of ways crypto traders can benefit from crypto derivatives, there are very few venues where they can be traded. Increasing the availability of derivatives to investors will improve the overall health of the market.
That’s why we built LXDX.
For more information on how to get started trading crypto derivatives, visit: