The cryptocurrency trading sector is gradually evolving into a complete ecosystem. Gone are the days when only conventional trading of coins was encouraged. The market has matured and has bestowed the traders with sophisticated and mature financial instruments – Crypto derivatives.
If you are looking to start trading derivatives, then this is the only article you need to read to get up to speed. I have used the Q&A format to cover most of the key concepts for the crypto derivatives.
What Are Cryptocurrency Derivatives?
Mathematics and financial markets walk on similar paths when derivatives come into the picture. The concept of derivatives was introduced in Mathematics. It referred to a value or a variable which has been derived from another variable. Similarly in financial markets, the derivative is an instrument that is derived out of some market products. Its price is dependent on the value of the underlying asset from which it is derived. The underlying asset can range from stocks, currencies, commodities, indices, etc.
When the underlying asset is a cryptocurrency, the derivative is referred to as cryptocurrency derivatives. It is a financial contract between two or more parties based on the future price of the cryptocurrency.
Futures Contract
What is a futures contract?
It is a derivative contract between two parties to buy or sell the underlying at a pre-defined price and on a pre-defined date in the future. The underlying in this case is the cryptocurrency. One who buys the contract is said to be in a long position and one who sells it is said to be in a short position. The pre-defined price is the price of the futures contract and the pre-defined date is termed as the maturity date of the contract. Such contracts are standardized and are traded on exchanges.
Let us understand the effect of changes in the price of the underlying cryptocurrency on the returns of the two parties. The buyer of the contract gains profit when the price of the underlying goes up because the contract allows him/her to buy the underlying at a cheaper price. In the same way, the seller is at the profit when the price of the underlying declines.
So while trading futures, all you need to know is – go long when the price is predicted to increase and go short when the price is expected to fall.
The futures contract in which the underlying is the cryptocurrency coin, then it is known as a cryptocurrency futures contract. For example, if the underlying is the Bitcoin, then it is called Bitcoin future contract and if it is XRP, then it is called a ripple futures contract.
Do I need to have cryptocurrency to trade cryptocurrency futures?
It is not important to have a cryptocurrency to trade cryptocurrency futures. The gains and losses of the futures contract are independent of the underlying. Let me explain it through example. Consider a Bitcoin futures contract. Assume there are two types of the futures contract on this coin:
Bitcoin settled: The gains or losses of this contract are in terms of Bitcoin and hence one needs Bitcoins to trade this contract.
USDC settled: The gains or losses of this contract are in terms of USDC and hence one needs USDC to trade this contract.
Thus, the Bitcoin future contract can have its profit or loss in potentially any fiat or cryptocurrency. So there is no need to have a particular cryptocurrency to trade futures of that cryptocurrency.
Example of a cryptocurrency futures trade
Assume that the current price of Bitcoin is $4000. Trader A thinks that the price will go up to approximately $4500 in a month’s time. He buys the contract from trader B that will allow him to buy Bitcoin at $4100 one month hence. In this case, trader A goes long the Bitcoin futures at $4100.
Profit/loss for Trader A = Current_BTCFutures_Price – $4100
Profit/loss for Trader B = $4100 – Current_BTCFutures_Price
As a matter of fact, the price of the Bitcoin futures typically tracks the current price of the Bitcoin. Also, at the time of maturity, the price of futures equals the price of Bitcoin. So if trader A holds the position till maturity and at that time the price of Bitcoin is $4300, then:
Profit/loss for Trader A = $4300-$4100=$200
Profit/loss for Trader B = $4100-$4300=-$200
Note that, we are considering the changes in the price of the futures contract and not the price of Bitcoin.
Espay’s crypto futures derivatives contract development can help you in developing a competitive platform for futures trading.
Options
What are Options?
Options are the types of financial derivatives that give the holder the right but not the obligation to buy or sell a certain number of an underlying asset at a pre-defined price at a pre-defined time. They are extremely useful to hedge the risk and protect the portfolio. As a matter of fact, if they are traded with precision, one can earn outsized trading gains.
Let us now understand what are crypto options.
Crypto Options are the options contract that has specific cryptocurrency as the underlying asset. Options enable traders to short the market (i.e. gain profit even though the price is declining). Thanks to options, crypto traders can now reap benefits from both bull and bear markets.
What are the types of Options?
Options are of two types namely call option and put option. These options consist of similar basic components – underlying asset, strike price, expiration date, and order size.
A call option is the right to buy an underlying asset (e.g. BTC or XRP) at a certain price (strike price) at a certain date (expiration date). A put option is the opposite of the call option, it is the right to sell the underlying instead.
Options are also classified into two more types namely European and American options. European options can only be executed at the expiration date. While the American options can be exercised anytime or on prior.
Examples of Cryptocurrency Options trade
Call Option Example
Underlying Asset – BTC
Strike Price – US $8000
Expiration Date – July 30, 2020
Order Size – 1 BTC
The option mentioned above gives the trader the right to buy 1 BTC at the US $8000 on July 30, 2020, no matter what the price of BTC is at that point in time. As of today, the price of BTC is $4500.
If the price of BTC does not cross the US $8000 at the expiration date, then it makes no sense to execute the option. It will be worthless (out of money – OTM) option.
But, if the price of BTC crosses the strike price, then it makes sense to execute the option and buy 1 BTC at a price (the US $8000) which is lower than the then market price. This will help the trader gain profit (in the money – ITM option).
Put Option Example
Consider the similar details as mentioned in the above example with the only difference being that you buy a put option instead of a call. Now trader has the right to sell the BTC at the US $8000. If the price of BTC falls below this price at or before the expiration date, then it makes sense to execute the option and sell 1 BTC at a price (the US $8000) which is higher than the market price leading to gain. The opposite will lead to the loss.
Espay’s crypto options derivatives contract development can help you in developing a competitive platform for options trading.
SWAPS
What are Swaps?
Swap is a contract between two parties to exchange one sum of money against another sum of money at regular intervals. It is obvious that the sums exchanged should be different. There can be the difference in amounts (say, one fixed and the other variable) or the exchange can be in different currencies. These two payments are the foundation for swaps. Typically, one of them is fixed while the other is floating (market price).
Consider the transaction between A and B. A like cars and would love to experience the feel of driving BMW. But he doesn’t want to own BMW. B has got BMW and he does not drive it often. He wants to earn some income by loaning out his car. Here, they sign a contract in which A will pay the rate of interest to drive B’s BMW for a short period of time. Here A is willing to swap an interest payment for the use of BMW. This contract is a swap. Here the interest is variable and the car is fixed.
When cryptocurrency is used as one of the foundations in the above-mentioned contract, it is called as cryptocurrency swaps. In cryptocurrency swaps, traders have no interest in owning or storing the coin, but they obtain the same economics through a swap. They want to participate in the price performance of the coin.
How are Swaps valued?
Swaps are valued at the existing spot price of the underlying asset. For example – consider the buyer of the ETHXBT swap. Here the buyer will pay XBT rate and receive ETH. The opposite case will exist if he/she wants to sell ETHXBT.
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