Introduction to Crypto Derivatives
Why Do You Need Them?
While people have been trading some form of options, the modern form of options contracts is the ones introduced when the Chicago Board of Options Exchange (CBOE) was formed on April 26 1973. The most commonly used derivatives in the traditional market include futures and options which are both exchange-traded and also forwards and swaps which are available over the counter (OTC).
Futures and options contracts can be created for any underlying asset such as stocks, indices, commodities, currencies and even cryptocurrencies. The number of options contracts alone traded globally has increased from 9.42 billion contracts in 2013 to 21.22 billion contracts in 2020. As this number keeps growing, we think it is really valuable to see if there is any scope of these derivatives in the cryptocurrency markets.
The most popular crypto derivative in the market is Bitcoin future. I thas been the most exchanged derivative in terms of volumes. While people started trading Bitcoin since its early inception, it was not until 2017 that renowned institutions like Chicago Mercantile Exchange decided to launch Bitcoin futures on its platform.
Today, Bitcoin futures are among the most prominently exchanged derivatives in the crypto space, with top exchanges like Binance recording billions of dollars in volume consistently.
So, what are bitcoin futures or futures in general?
A future is a standardized contract that gives you the right and the obligation after buying it, to buy or to sell a commodity in the future, at a fixed price settled when signing the contract. It is used in all sorts of industries such as oil, agriculture and even cryptocurrencies. Signing a futures contract requires no fees but the contract must be executed. This feature is the “obligation” part of the contract.
Future trading can be done for long term as well as short term purposes. If you expect the price of a certain cryptocurrency to fall, then you must short the token. This means you are selling the token at the current market price and will buy it back in future at the lowest possible price you are aiming. Anyone who believes that the price of a cryptocurrency will be higher than the current market price, the token must be longed meaning you buy the token at today’s price and sell it at the highest possible price.
Traders also gain access to leverage in most futures markets. Leverage is a strategy that allows you to trade futures contracts without having to pay upfront the full value of a contract. Traders can borrow the needed capital to finance the contract with a relatively smaller equity stake.
For example, Alice believes that the price of ETH will rise to $5000 in the next few weeks and the current price of ETH is $2500. She can take a leveraged position based on her risk appetite. A 1x position means she does not want to take any risk, whereas a 100x position means it is a very risky position. Suppose she is confident with her assumption and would like to enter the position with a $250 payment. This means that her position has been leveraged 10 times. As long as the price of ETH is rising, she is making money. In case the price of ETH falls below $2250, her order will automatically get liquidated and she will lose her investment of $250.
The above is an example of perpetual contracts. Then there are contracts with a given expiry date.
For example, Beth wants to buy BTC and expects that it will increase in the future. He decides to buy a futures contract on one of the futures trading platforms.
The price of one BTC is $30,000, he plans to buy 10 BTC, Consider, the cost for a single contract is $300.
Contract Cost = Number of contracts x Cost of each contract
In this scenario, he wants to buy 10 BTC, so the number of contracts is 10
Contract Cost = 10 x 300 = $3,000
Order Value = Cost of the contract / Entry price
Entry price is the current price of BTC, i.e. $30,000 = 3000/30000
Order Value = 0.1 BTC
Therefore, 0.1 BTC is the initial margin amount for a contract.
If he did not execute the contract on the expiry date, it is automatically designed to execute by calculating the average price in the last hour. Beth needs to pay an extra fee for the automatic contract execution. T
Beth will make a profit or loss depending on the price of BTC at the time of expiry. A rise in the price of BTC implies that Beth has made a profit and the difference between the current price and the price at which the contract was purchased is the profit per contract.
The chart below is the BTC Long-Short ratio which gives a perspective of the market in general. As long as the ratio remains at one, it means that an equal number of individuals are standing firm on long and short positions i.e, market opinion is unbiased whereas a proportion higher than one implies that the market is bullish and a ratio less than one would therefore demonstrate a bearish sentiment in the market.
Why Trade Futures?
There could be many reasons why one trades in futures, but the two most common reasons are-
- Risk Management
You might be holding Bitcoin and you are scared that the price of the cryptocurrency might fall in future. A futures contract allows you to lock the price at which you want to sell your Bitcoin thus guaranteeing a fixed income on a particular date. Bitcoin’s volatile nature and value swings require several people to adopt dynamic risk management strategies in order to reduce any losses due to its volatility in the market.
There are many traders who would like to take advantage of the price volatility of Bitcoin and would like to profit but such movements. As discussed above, you could long Bitcoin if you feel that the price of the cryptocurrency will go up in the future. Traders could also short the cryptocurrency if they believe that the price of it will fall at the time of expiry of the futures contract.
Bitcoin futures are famous because they permit the utilization of leverage, where traders can open positions bigger than their deposits, as long as they keep a satisfactory margin proportion to avoid liquidation of positions. Traders can adjust the margin on their positions as per their risk and reward needs.
- Underlying Asset Price Determination — The spot prices of the futures can serve as an approximation of Bitcoin’s price in the market.
Unlike futures where the buyer of the contract is required to execute the contract at the time of expiry, options are contracts that give the buyer the right, but not the obligation, to buy (in the case of a call option contract) or sell (in the case of a put option contract) the underlying asset at a specific price on or before a certain date.
While options are relatively new in the crypto space, they have been trading extensively on Deribit.
Our guide to options trading will teach you everything you need to know about options trading — from basic definitions to the greeks.
Scope of Derivatives in Crypto
Without derivatives traders and investors will not be able to hedge their risks or speculate on the price of the underlying assets which could be Bitcoin or Ethereum or any other cryptocurrency. The price of Bitcoin in 2017 rose exponentially creating an air pocket that was popped once Bitcoin futures were dispatched by CME and CBOE for the market shorters who believed that the cryptocurrency was overpriced.
Using these financial tools helps in the development of the cryptocurrency markets and acts as a catalyst for its future adoption. Additionally, the DeFi market has grown tremendously since the crash of March 2020. Since then, many derivatives trading protocols like Oddz have been launched that simplify the process the trading futures and options and also synthetic tokens. One of the biggest drawbacks of trading derivatives of centralized exchanges is the lack of sellers in the market that reduces the liquidity. In DeFi, several protocols, including Oddz, have been able to create products that remove the need for contract sellers, for example, you do not need an options writer to purchase a contract on Oddz. All you have to do is select the cryptocurrency, the strike price and the expiration date for your contract and purchase it using your USDC tokens. This model eliminates the need for writers and will therefore allow more traders to hop on to the platform to quickly trade options for example.
The future of the derivatives market is bright in the crypto market. This market is not as mature as the traditional one and therefore has a lot of potential and scope for growth and prosperity.
Oddz is a multi-chain derivatives trading platform that allows users to create, maintain, execute and settle trustless option contracts, conditional token agreements, perpetual and futures contracts in a fast, secure, and flexible manner.
It employs the synergies of Ethereum, Binance Smart Chain, Polkadot, Polygon and Chromia to unleash the potential decentralized derivatives market. It focuses on building solutions that can propel the DeFi ecosystem by simplifying derivatives trading and enhancing the user experience.