Crypto Derivatives Explained: Trading Futures & Options

Cryptocurrency is a relatively new and exciting development in the world of finance. It was built to disrupt traditional finance and create new pathways for transactions between users, a development that has since taken the world by storm.

One section of crypto that has seen a select number of traders be minted millionaires is crypto derivatives.

Crypto derivatives are assets whose value is backed by cryptocurrencies. The major derivatives available are futures, options, and perpetual contracts. Unlike traditional spot trading, derivatives trading is significantly more advanced and requires a deeper understanding of the market.

Derivatives trading is a slippery slope for many traders, especially in a relatively new sphere like cryptocurrency. While it has the potential to make you massive profits, there is also the possibility that you could make an equal amount of loss. 

To that effect, this article will go into more detail about crypto derivatives, how to trade them, and some of the best exchanges to use.

Crypto Derivatives 101: Understanding & Trading Derivatives

Derivatives are not new to finance. They date back hundreds of years and have long been used to make profits and hedge against risk. With the advent of cryptocurrency, they have slowly made their way over to this new area of finance, and many seasoned traders and beginners alike have flocked to it, making both mouth-watering profits and horrible losses. 

Crypto derivatives enable traders to speculate on the price of cryptocurrencies without ever actually owning them. They are in direct contrast to spot trading, which usually involves buying the cryptocurrency, holding it for a certain period, and then selling it off when its price rises.

With derivatives, you can make similar or even greater profits without ever having to actually buy the cryptocurrency itself. In the world of crypto derivatives, traders make money by speculating on the future price movements of a particular cryptocurrency.

Derivatives trading majorly comes in three forms:

• Futures
• Options 
• Perpetual contracts

Futures

A futures contract is a contract between two or more parties[usually the broker and the trader(s)] that agrees on a future price of a commodity that the trader will pay for at a later date.

Essentially, the trader takes on the major burden of risk but also the possibility of profit. 

For example, if a trader goes into a futures contract where he agrees to buy one Ethereum token at the current rate (say $4000), he has taken on the risk involved in the trade. 

From here, there are two possibilities. The first is the outcome he would likely be hoping for, which would be a rise in the price of Ethereum.

When the date of the contracts' execution comes, he will end up being able to buy at the agreed-upon price even though its price has now risen. He can then sell the Ethereum he has bought at the current market rate and profit from the price difference.

Conversely, the price of Ethereum could also fall during the same period, but he would still have to buy it at the agreed-upon price. The trader would then have to take a loss of the difference between the market price and the agreed price.

Options

Options are like futures contracts in that there is an agreement between multiple parties on an agreed-upon price to be paid in the future. The difference here is that while futures contracts obligate you to pay the price at the date of maturity, options do not.

When trading options, the execution of the contract is not necessitated, and the buyer can choose to go forward with the payment or not once the maturity date is reached.

This choice is a much more attractive alternative for many traders as it essentially minimizes the risk involved in the trade. Rather than being forced to take a bad deal if the contract does not end up in their favor, they have the opportunity to simply back out of it. 

However, you should note that, unlike futures contracts, options require an upfront premium to be paid. Irrespective of whether or not you choose to take the contract at the specified date, this amount goes to the other party.

Perpetual Contracts

Like the previous two, perpetual contracts are based on future dates. The difference here, however, is that these contracts have no expiry. Crypto traders are increasingly beginning to warm up to perpetual contracts due to the absence of a specific end date for the contract.

With this, they can hold positions open until they are personally ready to close them.

What is Margin Trading?

Rather than being a specific type of derivative trading, it is better to think of margins as an underlying feature of crypto trading that gives you the potential to make astronomical gains with relatively small investments. 

Margin trading allows you to increase your profits with leverage. The leverage here is a particular amount that is a multiple of the margin. The total amount of leverage on offer is up to the broker's discretion, and the trader has the option to trade in a leveraged position or not.

Take, for example, that you choose to enter a BTC/USDT futures trade. You could be willing to invest $100. This amount is called the margin size. Should you decide to, you could also take up a leveraged position with this margin.

An example would be a 10x leveraged position. With this, your initial $100 investment would become $1000. This larger amount allows you to make ten times the profit you would have made otherwise. 

A level of caution is required here. As positive as it seems to make such a large amount, it is also extremely easy to lose all of your investment because your losses are also multiplied to the same degree.

The broker minimizes their risk here by closing your position when you lose more than your initial margin. 

Where to Trade Crypto Derivatives

The top exchanges to trade crypto derivatives on are:

• Binance
• OKEx
• Huobi Global
• FTX
• Kucoin
• Gate.io

The largest and most trusted exchange by far to trade crypto derivatives is Binance. Since its establishment in 2017, the exchange has had enormous growth. As of today, it currently has the highest daily trading volume and is trusted worldwide.

One key feature of Binance that makes it a top contender is its 'leveraged token.' Leveraged tokens are a middle ground between the more conventional spot trading and margin trading.

Leveraged tokens give you exposure to leverage without having you manually open a margin. Rather, you buy a token that gives you the resulting value of a leveraged position.

Should You Trade Crypto Derivatives?

Crypto derivatives are a great source of income for anyone looking to invest some money. However, like anything financial, it is essential to do the proper research and fully understand what you're getting into before putting any of your hard-earned money into it.

Trading with leverage can be especially risky, even for people well versed in it. Liquidations from forcibly closed positions happen often, and it is best to be completely sure of your analysis before you take any positions.