What Are Bitcoin Derivatives?
A cryptocurrency derivative is a contract that may be executed for a certain amount of bitcoin or some other crypto. When a trader purchases a bitcoin derivative, he does not actually control the bitcoin that the contract represents. Rather, the trader enters into an agreement with the exchange or market maker which allows him to buy or sell the contract at the nominal value (price when bought) when exiting the trade. The difference between the nominal price and the spot (current) price represents his or her profit or loss.
Crypto derivatives are very suitable instruments for leveraging. Because a derivative does not physically represent its underlying asset, the contract may require a smaller down payment – or margin – to control a larger position.
For example, let’s imagine you recognize a bullish bitcoin trend emerging and decide to leverage your existing holdings to enjoy greater profit should the market move as anticipated. You buy a position of three bitcoin at a margin of 33%, which means that one bitcoin must be held as collateral.
In the event that bitcoin does act as expected, your profit would be amplified by 300%. For every dollar increase in the price, you would receive $3 rather than the $1 profit from the bitcoin held as collateral. On the other hand, should the value drop by $1 you would actually lose $3 worth of bitcoin from your one bitcoin margin.
Suppose then that the market continues to drop to the extent that bitcoin lost 34% of it’s value. As you have amplified your holdings by three times, this would mean the entire margin of one bitcoin would be lost – lost! Generally speaking, derivative exchanges will provide a “margin call” should your position be in danger of being liquidated. This margin call represents the amount needed to maintain a position, and can vary from between 10-50% of the initial margin required. If that threshold is passed, the exchange will liquidate your position and return whatever balance remains to your account.
Let’s have a look at the different sorts of derivatives currently available in the bitcoin market.
The two most popular derivatives types are futures and options, but in the cryptocurrency market only futures have really taken off. A futures contract is an agreement to deliver an underlying asset at a future date at the nominal price. When trading bitcoin futures, this is settled in either dollars or bitcoin itself, depending on the exchange.
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A crypto futures contract will generally trade above or below the spot price, depending on whether it is a bull or bear market; however it will almost always move in tandem with the spot market, following it as it goes up and down. As the settlement date draws nearer, the futures price will naturally gravitate closer and closer to the spot, until at settlement the contract will be liquidated at the current spot price. This price will be based on a transparent index generally consisting of blend of different bitcoin exchanges. The final price will also usually average prices from a few different time frames to mitigate against market manipulation.
When settled, the profitable side of the trade will be compensated by the losing side of the trade. While futures are an excellent tool for hedging crypto holdings – learn more about that here – spot derivatives are basically all about speculating with big leverage. Read more about the best bitcoin futures platforms.
Whereas futures contracts require the holder to buy the certain amount of bitcoin at the specified future date, options contracts offer the right, but not the obligation, to exercise the held contract. Option contracts trade with a price known as the premium, or the amount at which a certain option may be bought or sold. This premium gives the holder the right to exercise the option. In the event that the option for bitcoin is in the money – or lower than the current price of bitcoin – then the premium would be higher. In the event that the option is well out of the money – or higher than the spot price of bitcoin – the premium would be lower.
An option exchange will usually offer options at incremental strike prices – Bitcoin options, for instance, might be offered at every $500 or so – $7,500, $8,000, $8,500 etc. Traders receive the difference between the strike price and the market price at expiration or, if their option is out of the money, they receive zero and lose only the premium. Read more about the best bitcoin options platform.
It is more difficult to develop a healthy spot derivative because without a settlement date it is difficult to anchor the price to coincide with market reality. One alternative is to use spot margin from standard exchanges, like bitfinex, which offer 3:1 leverage, but these positions control actual bitcoin on the market, provided by lenders in exchange for interest payments. While a very good tool, leverage offered is limited and the interest rates can get high.
Bitcoin Contract for Difference (CFD) derivatives are a popular, if flawed, method to offer highly leveraged spot positions. Usually, CFDs are offered by operators that act as market makers, the counterparty to your trade. Not only do they act as the trade counterparty, they set the rates, and generally are not transparent about which, if any, index is being used. This will make the more untrusting among us a bit skeptical.
A newer, more transparent method of trading spot derivatives has been developed by large bitcoin futures exchanges like Bitmex. Traders on Bitmex may trade the spot market against one another with very high leverages, just like with standard futures. Every eight hours, one side of the trade will pay a funding rate to the other, which is set to jam the price back in line with the underlying spot index. For example, if the bitmex spot price were trading well above the market, the longs would be required to pay the shorts a certain percentage of the position at funding. This allows a standard exchange model, peer to peer, eliminating the conflict of interest that may arise in the relationship between trader and market maker in the CFD markets.
Use our derivatives comparison tool for more information on the different platforms available.