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Crypto derivatives: Everything you need to know

By Connor Freitas

What crypto derivatives are, how to start trading, and the potential legislative and regulatory issues surrounding them

In the financial world, there’s one thing that every trader and investor is keen to avoid: risk. Derivatives, a type of financial contract, are one way of mitigating it. Traditionally used for old-fashioned assets such as commodities, their application is practically limitless – and as a result, they’re beginning to make an appearance in the cryptocurrency world. In this article, we’ll explain what crypto derivatives are, how to start trading, and the potential legislative and regulatory issues surrounding them.

What is a derivative?

Before all of that, let’s recap what a derivative actually is. As the name suggests, the value of these contracts derives from an underlying asset. The asset in question could be agricultural produce such as coffee or sugar, natural resources like gold or oil, securities such as stocks, or indeed cryptocurrency.

Traders often end up buying and selling these assets in large quantities – and even the smallest price movements can end up having a big impact on their bottom line. Derivatives save the day by locking in the price of an asset for a set period of time, meaning a bakery can shield itself against volatility when purchasing sugar in bulk. These contracts date back thousands of years – and the first recorded derivative transaction was found in ancient Greece, about 600 BCE, when a philosopher predicted a bumper crop of olives and secured exclusive use of presses months in advance so he could cash in on demand for olive oil.

TYPES OF DERIVATIVES

Futures

Buyers are obliged to purchase assets for a fixed sum on a set date in future

Options

Buyers have the option to purchase assets for a fixed sum on a set date in future

Contract for difference

Traders can potentially profit on an asset’s price movements without owning it

Swaps

Two parties swap one type of interest rate, commodity or currency for another

How do cryptocurrency derivatives work?

Crypto derivatives come into their own because they can help traders protect themselves against volatility in the price of Bitcoin, Ether and other altcoins – irrespective of whether their value rises or falls.

Let’s imagine that one Bitcoin is currently worth $10,000, and Zoe thinks prices are going to decline. She can borrow five Bitcoins and sell them for $50,000. If the price subsequently falls to $6,000, Zoe can buy the five Bitcoins back for $30,000 and return them to the lender – leaving her with a profit of $20,000. This approach to crypto derivatives is an investment method known as “short selling.”

Tina thinks differently. She believes the current BTC price of $10,000 will rise substantially in the coming months – and is “going long.” As a result, she decides to enter into a call option to buy five Bitcoins for $10,000 each in six months’ time. Fast forward, and BTC/USD is trading at $16,000. Because she locked in the lower price, she makes a total saving of $30,000 when buying the cryptocurrency.

All of this assumes that the crypto derivatives have worked in their favor. If prices fell to $7,000 when it was time for Tina to buy her five BTC, she would be obliged to pay $15,000 more than the current market rate.

How to start trading crypto derivatives

To begin, investors need to register with a cryptocurrency derivatives exchange. Although the cryptocurrency markets do operate on a 24/7 basis, futures exchanges have set trading hours six days a week. Although most major platforms do allow margin trading – enabling users to take on a full position by making a smaller deposit – the required down payment is usually substantially higher than on the normal markets. For example, if Graham wanted to enter into a Bitcoin futures contract worth $20,000, he may need to keep $7,000 constantly in his balance to keep his contract in good standing.

Three dos – and three don’ts

· Do understand what you’re getting into. The potential for losses can be huge

· Do keep up to speed with the regulations surrounding crypto derivatives

· Do trade liquid assets, as you’ll be able to buy and sell more quickly

· Don’t trade without an exit plan – one for when it’s going well, one for when it isn’t

· Don’t be afraid to adapt to market conditions and adopt a new strategy

· Don’t enter into a position without being fully familiar with how an exchange works

Legal challenges ahead

Although the derivatives market is booming, it is important to make sure that the exchanges you use are legal in your jurisdiction. BitMEX, a Seychelles-based platform, is being investigated amid claims that American consumers were able to enter into futures contracts even though it is banned in the US.

Meanwhile, the UK’s Financial Conduct Authority is considering banning cryptocurrency derivatives altogether – a move motivated by concerns about the “extreme volatility” of assets such as Bitcoin, and fears that some consumers are entering into positions without fully understanding what they entail.

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