What are cryptocurrency derivatives and how do you make money on them?

1. What are derivatives?

A derivative is a financial contract for the future price of a cryptocurrency, security, commodity or service. The subject of such a contract is called an underlying asset. Sellers and buyers of derivatives do not own the underlying assets, but sell and buy the right to execute the contract.

2. Why are derivatives needed?

To reduce risk and make money on price movements. This is true for both traditional and cryptocurrency exchanges. Let’s explain it with examples.

If trader Vasily fears that bitcoin will fall to $3,000 by next Tuesday, he can make an agreement with trader Arkady to sell him bitcoins when the price goes down to $3,500. That’s how derivatives help reduce risk.

And if trader Gennady wants to buy bitcoins at $3.5 thousand before Tuesday, he can buy a contract from Arkady and then Vassily will sell the bitcoins to Gennady. Vasily will receive money from Gennady without waiting for the agreed price. By selling and buying this contract traders can make money depending on the price of the underlying asset. This is how derivatives are used to make money.

3. How do cryptocurrency derivatives make money?

Traders make money from changes in the price of the underlying asset. Since the future market price of the underlying asset is unknown, all traders assume the risk. If the commodity is cheaper at the time of execution, the seller makes a profit and the buyer is left with a loss. If the price went up, the buyer wins.

To increase the profit the trader uses the leverage – a loan provided by the exchange. The size of the leverage is proportional to the deposit made by a trader. Due to this the trader can carry out operations on large sums. The size of leverage depends on the exchange. Most exchanges provide the leverage with commission.

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Let’s say the current price of BTC is about $8,000. Arkady thinks it will fall. He enters 1 BTC, chooses the 10x leverage and sells 80,000 contracts at $8,000 for 1 BTC. In two hours, the bitcoin price falls to $7600. Then Arkadiy also buys the same contracts and receives 80 000/7600 – 80 000/8000 = 0,52 BTC to his balance. Now Arkady has 1.52 BTC on his account.

4. What types of cryptocurrency derivatives are available?

  • Futures
  • Forwards
  • Options
  • Swaps
  • CFD (Contract for Difference)

5. What are Futures?

A futures is an agreement to sell or buy an underlying asset at an agreed price in the future (hence the name). For example, you order a specific set of cars from a car dealership. It will be delivered in six months, and you will be obliged to buy the car at the agreed price.

There are also open-ended futures. They have no settlement or closing date, so you can buy and sell them at any time.

6. What is a forward?

A forward is an over-the-counter contract for the purchase and sale of a commodity in the future. It is similar to a futures contract, but less standardized. A futures is traded on an exchange, while a forward is traded through the OTC. For example, you commit to translating a book in the future and the publisher commits to pay for the finished work.

Bitcoin forwards are traded on the U.S. regulated exchange TeraExchange.

7. What is an option?

An option is a contract that gives the buyer the right, but not the obligation, to buy an item at an agreed-upon price. For example, you ask to hold on to an item until tomorrow because you do not have the money with you.

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Options trading is provided by Deribit and LedgerX.

8. What is a Swap?

A swap is two contracts: buying and selling the underlying asset and buying and selling the same asset in the future. It is a more complex version of a futures contract. For example, you buy a particular car, but agree with an acquaintance that you will sell that car to him at a higher price.

Perpetual swaps are available on BitMEX.

9. What is a CFD?

A CFD (contract for difference) is a derivative for the price difference of an underlying asset. If the asset becomes more expensive over the term of the contract, the seller pays the difference. If the price falls, the buyer pays it. Often, such contracts are open-ended and are closed by the party entitled to do so under the contract. For example, the store promises to pay the difference in price if you find the same product cheaper.

Cryptocurrency CFDs are available on the eToro platform.

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