What are crypto derivatives?
A derivative is a type of financial instrument that tracks the value of an underlying asset, such as a stock, bond, or cryptocurrency. Using derivatives, traders can construct different types of financial arrangements and capitalize on different market events.
With crypto derivatives, financial instruments derive their value from the price of a particular cryptocurrency, like Bitcoin (BTC) or Ether (ETH). This derivation provides indirect exposure to the price movements of cryptoassets.
How do derivatives work?
Derivatives represent financial contracts between two parties: a buyer and a seller.
Depending on the type of derivative, these contracts may bind a buyer to purchase an asset, and a seller to sell an asset. They can also require a particular transaction to take place on a predefined date, at a predefined price.
Though each type of derivatives contract is different, most consist of the following components:
An underlying asset
The underlying asset is the asset on which the derivatives contract is based. For crypto derivatives, the underlying assets can include different cryptocurrencies like Ethereum (ETH), Litecoin (LTC), Solana (SOL) and more.
The derivative contract's price goes up and down in tandem with the underlying asset's market price.
Quantity refers to the amount of the underlying asset traded under the terms of the derivatives contract. A single derivative contract could consist of several hundred units of a given cryptocurrency, such as Tezos (XTZ), Cardano (ADA), or Avalanche (AVAX).
The settlement date is the predetermined date on which both parties must exercise the contract.
Once the settlement date passes, the terms of the contract can be paid out in the underlying asset, or in the fiat equivalent value. However, it's worth noting some derivative products allow this date, known as the delivery date, to take place after the settlement date.
For other types of derivatives contracts, investors can close their positions at any time before the settlement date arrives. In some cases, such as perpetual swap contracts, investors can keep their positions open indefinitely.
Method of delivery
Physically delivered derivatives mean the actual underlying asset is exchanged between parties once the contract is executed. Therefore, a seller would have to buy or hold the underlying asset before entering into the contract to sell it to the buyer of the contract once the settlement date is reached. Upon settlement, the buyer would receive Bitcoin (BTC) and not the fiat equivalent.
With cash-settled derivatives, on the other hand, contracts are resolved using stablecoins such as Tether (USDT) or fiat. This resolution means that the underlying asset itself is not transacted between buyers and sellers — only the cash equivalent.
For example, if two parties are trading a cash-settled crypto derivative for one bitcoin, the fiat value of one bitcoin is transacted upon the execution of the contract instead of the bitcoin itself.
Cash-settlement is the most widely used method for resolving crypto derivatives contracts.
What are the advantages of crypto futures trading?
Despite their complexity, futures offer a variety of benefits over the spot market that some traders may need, depending on their expertise in the markets, trading strategies and risk appetite.
- Speculation: Futures allow traders to speculate on the future prices of specific cryptoassets and take advantage of price swings in either direction. Opening a short position on a futures contract is one of the easiest ways to profit as its underlying cryptoasset’s price falls.
- No asset ownership: Futures are a financial contract that provide exposure to cryptoasset prices without having to take ownership of the cryptoasset itself. Traders can buy a contract and recognize their profit without ever having owned, transacted or custodied the underlying cryptocurrency.
- Fees: Futures trading fees are generally much lower than spot trading fees. Kraken Futures offers one the most competitive fee structures in the crypto futures market, with fees as low as 0.01%.
- Leverage: Futures allow traders to use leverage. This is built into the contract and allows for more capital-efficient trading while also ensuring an account balance does not go negative. Leverage positions can be liquidated – see our liquidation FAQ here.
- Hedging: If you own a cryptoasset, you can enter into a short futures position which reduces your exposure to (or “hedges” against) falling prices. This can be an effective strategy to protect a cryptoasset against downward price movement without having to sell the asset itself. You can learn more about different hedging strategies in our article What is Hedging?
- Arbitrage opportunities: Futures allow you to capitalize on crypto market inefficiencies. There may be instances when you can lock in profits by going short on a futures contract while going long on the underlying cryptoasset in the spot market.
Why use crypto derivatives?
There are several advantages and unique capabilities that derivatives products offer over buying and holding cryptocurrencies (known as spot trading). Some of these benefits include:
- Increased liquidity: Derivatives markets often attract a larger number of speculative traders that have a higher risk tolerance. This level of increased participation from high-risk traders creates higher levels of trading activity.
- Benefit from decreasing price: Crypto derivatives grant the opportunity to profit from the future price movements of an asset. Because of this, traders can open short positions that allow them to profit if the asset's price falls.
- Hedge against risk: Derivatives allow traders to hedge against potential losses in their positions by placing separate, opposing trades.
- Diversification: Derivatives allow traders to construct different types of trading strategies that are not possible with regular spot trading.
- Trade with leverage: Traders using derivative products can increase their trade size by borrowing funds from a third-party. This process is known as leverage or trading on margin, and can help amplify the profits from winning trades or deepen losses.
Types of crypto derivatives
Crypto futures are derivatives contracts that allow investors to bet on the future price of a cryptocurrency.
The buyer and seller first agree on a price and date to settle a trade. Futures traders can take either a long or short position on the contract's underlying asset. Long positions allow traders to benefit if the asset's price rises above the pre-agreed futures contract price, while short positions allow traders to benefit if the asset's price falls below the futures settlement price.
Before a futures contract expires, both long and short traders can choose to close out their position. For long traders, this means selling the futures contract to someone else. For short traders, it means buying back the underlying asset.
Investors trade futures contracts on dedicated futures exchanges that differ from standard spot exchanges.
It is important to understand that futures are zero-sum products, meaning each futures contract will have a loser and a winner. The resulting difference between the agreed upon contract price and the market price of the underlying asset at the time of expiration represents the profit or loss of the winner and loser, respectively.
Advantages and disadvantages of futures
- Futures allow investors to hedge against risk by locking in a future price for a particular asset.
- Futures speculate on the future direction of a particular asset, allowing investors to profit from price movements.
- Futures help diversify a portfolio, as they are uncorrelated to the stock market.
- Financial futures are highly leveraged instruments, meaning that investors can lose more money than they have invested.
- They are complex instruments and require a high degree of knowledge and experience to trade successfully.
- Financial futures are subject to market volatility, meaning that prices can move quickly and unexpectedly.
Options contracts give buyers the right, but not the obligation, to buy or sell an asset at a specified price.
Depending on the style of option, buyers may exercise this type of contract at any time before expiry, or only at the point of expiration. These are known as American and European style options, respectively.
Options contracts differ from futures contracts because there is no commitment for a buyer to buy or a seller to sell if the option contract becomes unprofitable.
With options, the right to buy is known as a call option, while the right to sell is called a put option.
An option contract consists of several components:
- Strike price: The price at which the buyer can exercise the contract.
- Termination date: The time when the option to exercise the contract ends.
- Premium: The amount the investor must pay for the opportunity to exercise the contract.
Because option buyers can choose to not exercise the terms of the contract if it becomes unprofitable, they pay a fee to the option seller in the form of a premium.
The premium serves as compensation in the event the buyer decides to let the option expire without exercising it.
Options and premiums are important. If there wasn't any premium to pay, anyone could enter into these types of contracts without putting up any capital first. Additionally, there would be no financial incentive for option sellers to create contracts.
Advantages and disadvantages of options
- Flexibility: Options provide investors with the flexibility to choose from a variety of strategies to meet their investment goals. Options can hedge against market volatility, or speculate on price movements.
- Increased capital efficiency: Options allow investors to leverage their capital by controlling a larger position with a smaller amount of capital. $1,000 worth of options premiums can provide exposure to much larger quantities of an underlying asset compared to buying $1,000 worth directly.
- Low cost: Options premiums are usually much cheaper to buy than other derivatives such as futures contracts. For example, a single CME Bitcoin Futures contract is worth 5 BTC (around $150,000 at press time).
- Risk: Depending on leverage, options contracts can go out-of-the money faster than when simply holding the underlying asset.
- Complexity: Options can be complex and difficult to understand. Investors should be sure to understand the risks and rewards associated with each option before investing.
- Time Sensitivity: Options have an expiration date, which means that investors must be aware of when their options will expire.
Perpetual futures contracts (perps)
Perpetual futures contracts, also called perps or perpetual swap contracts, are like regular futures contracts. They let people bet on the future price of an asset.
Like futures contracts, perpetual contracts follow the value of an underlying asset such as a cryptocurrency and represent zero-sum trades.
The main difference between perpetual futures and traditional futures is that perps have no predetermined expiration dates. Traders can keep their perpetual contracts open for as long as they choose.
Another key difference is how perpetual futures contracts track the market price of their respective underlying assets.
Perpetual derivatives use a funding rate mechanism to keep the value of the contract aligned with the value of the underlying asset. This system forces either long position holders to pay a fee to short position holders, or vice versa.
Long positions pay short positions when the contract price is higher than the value of the underlying asset. Short positions pay long positions when the price of the contract is lower than the value of the contract.
This system is designed to maintain an equilibrium between long and short traders. If there are too many people going long, for example, the system incentivizes other investors to go short and collect funding rate fees.
Funding rate mechanisms vary between platforms, but traders usually pay or receive these fees every eight hours.
Arbitrage traders play an important role in maintaining the funding rate balance by taking opposition positions to most other perps traders. These types of traders hedge their perp contract exposure, meaning they open opposing trades to cancel out losses, while still capturing the funding rate fees.
Investors can trade perpetual swaps with leverage. Platforms require investors to deposit an initial margin and maintain a certain balance to open these types of positions. Because of that, liquidation risk still applies.
Advantages and disadvantages of perpetual futures
- High leverage ratios are available on some exchanges.
- Lower barrier to entry than some futures products.
- Low-risk profit opportunity for delta neutral arbitrage traders or market makers.
- Indirect exposure to the cryptocurrency market.
- High liquidation risk, especially when using large amounts of leverage.
Trading crypto derivatives using leverage
Investors trading derivatives contracts can take advantage of leverage, which offers greater exposure to a trade position than the same capital would purchase in the spot market. For example, using 5x leverage, a trader could buy a $5,000 derivatives contract with a $1,000 deposit. The capital deposited to buy or sell derivatives contracts is called initial margin.
A second account holds maintenance margin, a deposit at least half the size of initial margin. Maintenance margin allows a trader to sustain losses to a certain point without having their derivatives position liquidated by the exchange.
If a leveraged derivatives trade is successful, traders can make significant profits from a comparatively small initial investment (as compared to the spot market).
For example, if a trader buys one bitcoin at $30,000 on the spot market, BTC has to rise to $60,000 for a 100% gain. Likewise, BTC has to go to $0 to yield a 100% loss. The trader’s gain or loss is exactly the same as BTC’s percentage gain or loss.
Trading futures at 5x leverage, an initial margin deposit of $30,000 allows a trader to buy five bitcoins at $30,000 each, for total trade exposure (or notional value) of $150,000:
- Because of this leverage, the BTC price only has to rise 20%, to $36,000, for the trader to earn a 100% gain on his $30,000 initial margin ($150,000 notional value * +20% = +$30,000).
- However, if the BTC price falls 20% to $24,000, the trader will have lost 100% of his initial margin ($150,000 * -20% = -$30,000).
In this way, derivatives allow traders to amplify their returns to a greater degree than spot trading. But remember, with great leverage comes great responsibility. As quickly as leverage turbocharges profitable trades, it accelerates losing ones.