Crypto’s spot trading markets are simple. Buy or sell bitcoin at the market price, whenever and wherever you want, no funny business.
However, yet more money can be made (or lost) through derivatives trading. Crypto derivatives trading refers to the buying and selling of financial contracts that relate to cryptocurrencies, such as futures and options.
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In effect, these contracts involve trading contracts about cryptocurrencies – rather than trading and holding the cryptocurrencies themselves. These contracts are generally fulfilled if certain things happen, like the passage of a set amount of time or if a cryptocurrency reaches a certain price. But why would anyone bother with these markets when they can trade spot? We’ll explain.
Crypto derivatives – explained
Derivatives are financial contracts that relate to some claim about an underlying asset – in this instance cryptocurrencies. There are innumerable such contracts but two dominate in cryptocurrencies: futures and options.
Futures contracts are financial instruments that represent claims to buy or sell an asset in the future at a predetermined price. They say something like, “I agree to buy bitcoin for $20,000 next June, no matter its price today.”
Options contracts are similar but they provide the option, and not the obligation, to buy that asset in the future. For instance, the agreement might be: “You agree to sell me your bitcoin for $20,000 next June, if I want it at that time. If I don’t, you keep it.” Like futures contracts, options contracts are bets on the future price of bitcoin – although options have a get-out clause.
In crypto, there is also something called a perpetual futures or perpetual swap contract, which is a futures contract that never expires and can be held indefinitely.
There are countless more derivatives contracts in conventional finance, such as banker's acceptance, forwards and swaps, each of which greases the wheels of the financial markets in a slightly different way.
Crypto has many other unique products that can be categorized as derivatives, such as stETH, a derivative token that represents claims on ETH staked in Ethereum’s proof-of-stake system. But this piece is focused on the contracts that will be familiar to those who have traded traditional finance derivatives.
Why trade crypto options and futures?
Options and futures contracts represent bets on the future price of a cryptocurrency. But so does spot trading, where speculators buy low in an attempt to sell high in the future. So why bother with derivatives trading?
One answer is simple: leverage. Options and derivatives contracts allow you to buy more cryptocurrencies with your capital than a simple spot trade. When a trader locks in a price to buy, say, bitcoin in six months, they only have to put up a fraction of the price of that bitcoin today.
While they promise to have the money in the future – and will be liquidated if it looks like they won’t be able to afford the trade – they have bought bitcoin on the cheap. So, when they come to sell that bitcoin after the contract expires, the trader could magnify their profits. Of course, they could just as easily magnify their losses.
You can also gain leverage with spot trades to increase by borrowing money to fund your trade. This, of course, magnifies risk. A trade made on 2.5x leverage could increase profits by 2.5x – but they could also increase losses by the same amount.
Managing risk and hedging
Another answer is that derivatives let traders shuffle their money around to manage risk – known as hedging. In the real world, farmers like derivatives because they can lock in a price for their crop to avoid worrying about price volatility. For instance, a soybean farmer can sell crops before they are even planted through soybean futures contracts. It allows a farmer to budget for that set price without worrying about huge fluctuations that could rise or fall depending on inflation or if the marketplace is flooded with a hearty soybean harvest.
On the buying side of the contract, the buyer gets to lock in what he hopes will be a lower price than market rates in the future, but meanwhile she can use that capital to invest however she wants. It’s the same with cryptocurrencies – until the contract matures, a trader can do what he likes with the rest of how money – it isn’t locked up in a bitcoin trade.
Regulation provides a third answer. If you want to trade bitcoin on a regular exchange like Schwab or Fidelity – i.e., not a cryptocurrency exchange – one of your only choices is to use derivatives like bitcoin futures or options on bitcoin futures.
There are also cryptocurrency exchange-traded funds (ETFs) and trusts on many traditional exchanges. These are financial vehicles that hold bitcoin on behalf of their investors, then trade on a regular stock exchange, just like Google or Apple stock.
However, the U.S. Securities and Exchange Commission has long denied applications for a spot bitcoin ETF on the premise that the price of bitcoin is inherently manipulable. It has, however, approved ETFs for bitcoin futures. So, derivatives contracts are useful for those who want to invest in bitcoin but can only do so within the walls of the conventional financial system.