What are Crypto Derivatives Trading? Types, Pros and Cons

Crypto derivatives offer novice investors a unique opportunity to diversify their portfolios and potentially amplify returns in the volatile crypto market. These financial instruments derive value from underlying cryptocurrencies like Bitcoin or Ethereum, allowing you to speculate on price movements or hedge existing holdings. 

Popular derivatives include futures, options, and perpetual contracts, each with a risk and reward profile. Understanding these tools allows you to better understand the crypto market and tailor your investment strategies for greater potential gains.

What is a Derivative? Definition of Derivative

A Derivative or a derivative asset/commodity is an asset/commodity whose value is dependent on the underlying asset. Derivatives are contracts that determine how parties will exchange assets in the future, with the value of the exchange tied to a separate underlying asset.

Some of the most popular derivatives that are available in the traditional market include:

• Commodity Derivatives are based on the prices of commodities like gold, oil, wheat, or even coffee beans.
• Currency Derivatives are investments in which the underlying asset is a currency exchange rate, such as the US dollar price against the Japanese yen.
• Interest Rate Derivatives based on interest rates, such as the yield on government bonds.
• Index Derivatives based on the value of a market index, like the S&P 500 or the Nifty 50
• Credit Derivatives: which transfer credit risk from one party to another.

What is a Crypto Derivative?

A crypto derivative, or a crypto derivative contract, is a financial instrument whose value is derived from an underlying cryptocurrency (like Bitcoin or Ethereum). Crypto derivatives are contracts that determine how parties will exchange these assets in the future, with the exchange’s value tied to the underlying cryptocurrency’s price.

Why Should You Know About Crypto Derivatives?

Basic Cryptocurrency Trading has its Limitations

If you want to maximize your potential in the crypto market truly, you have to go beyond simply buying and holding cryptocurrencies. You need to—

1. Diversify your Investments
2. Minimize Risks offered by the volatility of Cryptocurrencies and
3. Adapt strategies that suit the ever-evolving market.

Benefits of Using Crypto Derivatives

Crypto derivatives empower traders to go beyond simple buy-and-hold strategies. Crypto Derivatives, open up a broader range of strategies, giving you more flexibility and control:

• Hedging: Protect your existing crypto holdings, similar to insurance, from price volatility.
• Speculation: Take advantage of market fluctuations to potentially profit from rising and falling prices.
• Leverage: Amplify your gains (and losses) using borrowed funds, allowing for greater exposure with less capital upfront.

The strategies mentioned here are just a glimpse into the vast potential of crypto derivatives. As the market evolves, new and innovative ways to utilize these instruments continue to emerge, offering traders ever more creative approaches to navigating the complexities of the crypto market.

Most Popular Crypto Derivative Instruments

While the crypto derivatives market is constantly evolving with new instruments emerging, four main types dominate the landscape and are widely used by traders and investors.

The following table will give you an overview of what each means—

Table showing Overview of Popular Crypto Derivatives

10 Derivatives in the Cryptocurrency Market You Must Know About

Now lets take a look at some of the popular derivative assets available in the Crypto Market:

1. Crypto Futures

A Crypto Futures Contract is a Cryptocurrency Derivative contract in which the parties involved enter into a contractual obligation to Buy or sell Cryptocurrencies at a Fixed price on a pre decided future date.

Crypto futures contracts can be either cash-settled or physically settled, which means that the contractual obligations can be settled either via Fiat Currency/Stable Coin or the delivery of the actual Cryptocurrencies as agreed to in the contract.

This means that you can use Crypto Futures to—

• Hedge against price fluctuations in the cryptocurrency market
•  speculate(perform speculative trading) on the future price movements of cryptocurrencies without needing to own the underlying assets.

Through Speculative Trading, Cryptocurrency Futures Contracts also open up the possibility of 

using Leverage, a key feature in speculative trading. Leverage will enable you to amplify your potential returns by controlling larger positions with a smaller initial investment.

2. Crypto Options

Crypto Options are similar to Futures but distinct from them. When you buy a Crypto Options contract, you are buying the right but not the obligation to sell/buy the underlying cryptocurrencies.

Similar to futures, Crypto Options will also allow you to 

• Manage Risk: Hedge against price volatility in the cryptocurrency market by leveraging options contracts to mitigate potential losses.
• Speculate Responsibly: Engage in speculative trading based on market expectations without the requirement of owning the underlying assets, providing flexibility in trading strategies.

Options are better than crypto futures because they limit your losses while still having a chance for big gains.

3. Crypto Swaps

Crypto Perpetual Contracts, or perps, are a unique type of derivative in the cryptocurrency market. They are a kind of Future contract, and so sometimes, they are also referred to as Perpetual Futures. Similar to futures, they involve an agreement to buy or sell a cryptocurrency at a predetermined price. However, unlike futures, perps do not have an expiration date, allowing traders to hold positions indefinitely.

Perpetual contracts are often called “perpetual swaps” because they share similarities with traditional swap contracts. Both involve the exchange of cash flows based on the performance of an underlying asset. However, perps are specifically designed for the crypto market and incorporate the unique feature of no expiration date.

• Leveraged Trading: Perps offer high leverage, allowing traders to amplify potential profits (and losses) with a smaller initial investment.
• Hedging: Traders can use perps to hedge their spot positions in the cryptocurrency market, mitigating potential losses from adverse price movements.
• Directional Trading: Perps enable traders to speculate on the future price direction of a cryptocurrency without owning the underlying asset.

Unlike regular futures that expire, perpetual contracts never end, allowing traders to hold positions for as long as they want. This makes them easier to use for long-term trading strategies. Here’s an example which will simplify the comparative advantage of Perps to Futures—

• Priya buys a Bitcoin futures contract expiring on December 31st at ₹10 lakhs per BTC. If Bitcoin’s price rises to ₹15 lakhs by December 31st, she can buy it at the agreed-upon price and sell it immediately for a ₹5 lakh profit. However, if the price drops to ₹8 lakhs, she’ll be forced to buy at ₹10 lakhs, incurring a ₹2 lakh loss.
  
• Raj, instead, buys a Bitcoin perpetual contract at ₹10 lakhs per BTC. Believing in Bitcoin’s long-term potential, he holds onto the contract for over two years. During this time, Bitcoin’s price fluctuates, but Raj doesn’t worry about expiry. When Bitcoin eventually reaches ₹50 lakhs, he sells his contract, making a substantial ₹40 lakh profit without the need to roll over any positions.

4. Crypto Forwards

Forward contract is another crypto derivative that is very similar to Crypto Futures. When buying a Crypto Forward contract, you are entering into a private agreement with another party (counterparty) to buy or sell the underlying cryptocurrency at a specified price on a future date. This differs from futures contracts, standardized agreements traded on a public exchange.

Futures vs Forwards: Forward contracts are better than futures for institutions or individuals who require highly customized terms and are willing to take on counterparty risk. They offer greater flexibility but are not as easily traded as standardized futures contracts.

5. Crypto Non Deliverable Forwards

Crypto Non-Deliverable Forwards (NDFs) share similarities with both Futures and Forwards, as they all involve agreements to buy or sell cryptocurrencies at a predetermined price on a future date.

But unlike futures and options contracts, which can be settled by physically delivering the underlying asset or cash equivalent, NDFs are settled by exchanging the difference between the agreed-upon price in the contract and the spot price of the underlying cryptocurrency at a specified future date. This means that the actual cryptocurrency is never delivered, hence the term “non-deliverable.”

Crypto NDFs vs. Futures vs. Forwards: NDFs offer a unique way to gain exposure to cryptocurrencies that are otherwise difficult to access or trade. While they share similarities with futures and forwards, the key difference lies in their cash settlement and OTC nature, making them more suitable for institutional investors and specific risk management scenarios.

6. Crypto Yield Swaps

Crypto Yield Swaps are another specialized derivative product in the cryptocurrency market. 

Crypto yield swaps let you exchange the interest (yield) you earn on your crypto with someone else. This can help you lock in a fixed rate, manage risk, or potentially earn more if you bet on the market correctly.

This crypto derivative is similar to traditional interest rate swaps where two parties exchange a fixed or floating yield on a specified cryptocurrency over a predetermined period. The “yield” in this context refers to the return generated by staking or lending the cryptocurrency.

Here’s an example to illustrate it further: Imagine you own Ethereum (ETH)  which you can use to earn interest (yield) by “staking” it on a platform like a bank deposit. However, you might worry about the interest rate going down in the future. With a Crypto Yield Swap—

1. You find another person (Raj) who owns ETH, too.
2. You agree to swap your ETH interest (yield) with Raj for a fixed period. This means you’ll give up the right to any potential increase in the interest rate in exchange for a guaranteed fixed rate. For example, if the market interest rate for staking ETH goes up to 8% in the future, you won’t benefit from that increase because you’re locked into the 5% rate agreed upon with Raj.
3. You might agree to receive a fixed 5% interest from Raj while he receives your variable interest, which could fluctuate based on market conditions.

Why do this?: You get a guaranteed 5% interest, no matter what happens to the market rates. This protects you from potential interest rate drops. Meanwhile, Raj can earn more than 5% if the market interest rate increases.

7. Crypto Token Warrant

When you are buying a Crypto Token Warrant, you are buying the right, but not the obligation, to buy a specific amount of tokens at a predetermined price (exercise price) before a specified expiration date.

Token Warrants are different from options because:

• Token warrants are typically issued by companies as part of a fundraising round, while options are traded on exchanges.
• Token warrants often have longer expiration dates than traditional options.
• The exercise price of a token warrant may be lower than the expected market price of the token at the time of issuance.

Unlike options, token warrants are generally issued during fundraising rounds, have longer expiration dates, and may offer lower exercise prices. These characteristics distinguish token warrants as a unique investment vehicle within the cryptocurrency market.

8. Crypto Variance Swaps

Crypto variance swaps are a type of crypto derivative that allows traders to speculate on the future volatility of a cryptocurrency. Two parties agree to exchange payments based on the realized volatility of the underlying cryptocurrency over a specific period. 

The buyer of the swap pays a fixed amount upfront (the premium), while the seller pays out an amount calculated based on the actual volatility of the cryptocurrency during the contract period.

Crypto Variance Swaps vs. Crypto Options

1. Focus: Variance swaps focus solely on volatility, while options consider price direction and volatility.
2. Payoff: Variance swap payoffs are linearly related to realized volatility, while option payoffs are non-linear and depend on both price and volatility.
3. Purpose: Variance swaps are primarily used for pure volatility trading and hedging against changes in volatility, while options are more versatile and can be used for various strategies involving both price direction and volatility.

9. Crypto Inverse Futures

Crypto Inverse Futures are a type of crypto derivative contract where the underlying asset (e.g., Bitcoin) is the base currency, and the quote currency (e.g., USD) is used to determine the contract value. This means that the contract is priced and settled in the base currency, unlike traditional futures where settlement is in the quote currency.

Crypto Inverse Futures vs. Crypto Futures

• Quote and Base Currency: Inverse futures use the underlying asset as the base currency, while traditional futures use it as the quote currency.
• Settlement: Inverse futures are settled in the base currency, while traditional futures are settled in the quote currency.
• Margin and Profit/Loss: In inverse futures, margin and profit/loss are denominated in the base currency, while in traditional futures, they are denominated in the quote currency.

Inverse futures provide an alternative way to trade cryptocurrencies, particularly for traders who hold the underlying asset and want to hedge their exposure. However, the inverse price relationship and potential for increased volatility require a thorough understanding of the market dynamics before trading.

10. Crypto Power Perpetual Derivatives

First introduced in 2021, Crypto Power Perpetuals are a relatively new and less common Crypto derivative. They offer a unique way to gain leveraged exposure to a cryptocurrency’s price volatility. Instead of being directly linked to the price of the underlying cryptocurrency, Power Perpetuals are linked to a power (exponent) of the underlying asset’s price. For example, a power of 2 would mean the contract value is tied to the square of the underlying asset’s price.

Being linked to an exponent of the asset’s price means you can achieve magnified gains (or losses) from even small price movements in the underlying asset, making it ideal for traders seeking leveraged exposure to volatility.

Conclusion

As the cryptocurrency market continues to evolve, so too do the opportunities for savvy investors. Crypto derivatives, while complex, offer a path to diversify and potentially maximize gains. Remember, knowledge is your most powerful asset in this space. Do your own research to empower your investment journey, and approach these instruments cautiously. That is where Mudrex can help you. Mudrex’s Comprehensive Crypto Knowledge platform is the best resource to help you get started with. 

By staying informed and strategic, you can navigate the exciting world of crypto derivatives and unlock new possibilities for financial growth.

Download Mudrex and Start your Crypto Journey Now

FAQs

1. What are the different types of crypto derivatives?

Crypto derivatives are financial contracts that derive value from an underlying cryptocurrency (like Bitcoin or Ethereum). The main types include futures, options, and perpetual contracts (a type of future without an expiry date).

2. What are the pros and cons of derivatives?

Derivatives can be powerful tools. On the plus side, they allow for hedging (protecting against price drops) and the potential for higher profits through leverage (borrowing to increase your position). However, leverage also means greater risk of losses. It’s crucial to understand these instruments thoroughly before using them.

3. What are the pros and cons of cryptocurrency?

Cryptocurrency offers the potential for high returns, is easily accessible for trading, and operates on a decentralized system. However, the market is known for its volatility (large price swings), and investments can be lost due to security risks like hacking.

4. What are the four types of derivatives?

While there are many derivative types, the four main ones are:

• Futures: Agreements to buy or sell an asset at a set price on a future date.
• Options: Contracts that give you the right, but not the obligation, to buy or sell an asset at a certain price.
• Forwards: Similar to futures, but traded directly between parties instead of on an exchange.
• Swaps: Agreements to exchange one type of cash flow for another.