Understanding Crypto Derivatives?

Crypto derivatives are financial instruments that derive their value from underlying crypto assets. Traders place their bet based on speculation of the price movements of crypto tokens, and can choose to either sell or buy the asset. The transaction can either happen through physical delivery of crypto tokens, or directly through cash settlement into the trader’s account without owning the asset.

Being a high-risk financial instrument, advanced traders can heavily maximize gains from crypto derivatives. However, the crypto market is extremely volatile and derivatives can have the opposite effect due to fluctuation on price movements—making their investment portfolios much riskier.

Different Types of Crypto Derivatives

Crypto derivatives are complex financial contracts that take place between a buyer and seller, and often corroborates with high-risk, high returns strategies. Crypto exchanges facilitate traders to invest in derivatives that come with three variations: crypto futures contracts, perpetual contracts, and options.

Crypto Futures Contracts

Crypto exchanges facilitate crypto futures contracts between two parties agreeing on the predetermined price for buying and selling crypto tokens, such as Bitcoin or Litecoin, and comes with an expiration date for the contract to end. At the time of contract expiration, if the market price of the said cryptocurrency goes above the set price, the buyer makes a profit. Sellers will profit if the market price falls below the predetermined price.

To cite an example, say X agrees to buy Litecoin from Y via crypto futures contract on WazirX at a set price of INR 7,045.72 on the last Friday of the month at 8:00 UTC. If the market price of the cryptocurrency goes up by 20%, X can either choose to buy Litecoin from Y at the predetermined price of INR 7,045.72 instead of the increased price, or get the increased amount credited into the account. Similarly, Y will profit by the percentage of the decreased value of the set price against the market price of the crypto.

The process of buying crypto tokens on crypto exchanges through crypto futures contracts is known as long position, and short position for selling. The transaction can either happen through physical delivery of crypto tokens, or directly through cash settlement into the trader’s account without owning the asset.

Components of crypto futures contracts

• Contract expiration: Crypto futures contracts have a predetermined expiration date (usually eight hours on most crypto exchanges) which the buyer and seller are obligated to settle at the pre-agreed price of the crypto token. It is one of the key differentiators from crypto perpetual contracts, which is another type of derivatives.
• Units per contract: It is an important component of crypto futures contract that represents the amount and value of each (usually in USD depending on the exchange) crypto futures contract and varies among crypto exchanges.
• Leverage: Crypto exchanges allow traders to maximize returns on crypto futures bet. Remember, leverage substantially increases the risk of losing money, and the investment technique is recommended to be used only with caution.

Crypto Perpetual Contracts

Similar to futures contracts, crypto exchanges facilitate traders to bet their investment on perpetual contracts. The key differentiator, however, between the two financial instruments or derivatives is that the component of “contract expiration” is taken out from perpetual contracts. This means, there’s no expiration date and traders can choose to speculate the market price of the underlying crypto and hold their position (long or short) for an indefinite period — provided they agree to pay the funding rate (the spot price of the crypto), which is usually after eight hours in most crypto exchanges. Profitable traders can choose to either withdraw their earnings, or continue to hold their positions.

Crypto Options

Another type of derivatives that has gathered popularity in the world of crypto trading is options. Such a type of financial instrument gives traders the option to fulfill the contract, but doesn’t bind them to buy or sell the underlying crypto at a predetermined price on or before the expiration date. Crypto options has three main components, as follows:

• Premium: The price buyer pays the seller to enter a crypto options contract. 
• Strike price: The fixed price at which buyer and seller agree to enter the contract.
• Expiry date: The date at which the final settlement is carried out.

Crypto options have two variants. Call option allows traders to buy crypto tokens at a price lower than the current rate. Put option, on the other hand, allows traders to sell it above the market price. Remember, in both options, traders are free to exercise their right to fulfill the contract without obligation to buy or sell the underlying crypto.

Pros and Cons of Crypto Derivatives

How To Start Investing on Crypto Derivatives

Before investing in crypto derivatives, it is important to become familiar with the process of cryptocurrency trading, obtain appropriate financial advice and only invest what you can afford to lose.

The process to start investing in crypto derivatives includes choosing the crypto exchange, and following the self-explanatory registration process. Here’s a step by step process to start investing on crypto derivatives:

• Step one: The first step to trading on crypto derivatives is to open an account with a crypto exchange using your email address, and setting up a password. This process will be followed by verifying the OTP sent to your registered email.
• Step two: In India, it is mandatory to submit KYC details, including your PAN card and Aadhaar Card details before you start investing in cryptos. Some exchanges require OTP verification for Aadhaar.
• Step three: Once the verification is processed, you are all set to start the trading. The next step is to add funds to your account by linking your bank account, authorizing wire transfer, or making a payment using your credit or debit card.
• Step four: Create wallet setups through crypto wallet, which is a software program used to manage cryptocurrency where you can send, receive, and store Bitcoin, Litecoin, Dogecoin, and other cryptocurrencies,
• Step five:  Place your crypto derivatives order by selecting the crypto pair, such as BTC/USDT, DOGE/USDT, and selecting your position whether to buy or sell.

Related: How To Buy Cryptocurrency

Bottom Line

Crypto derivatives involve speculating price movement of underlying cryptocurrency on the market, often corroborates with high-risk, high-return strategies. For less advanced traders, derivatives require extensive research and in-depth knowledge of crypto trading and market movements, and usually involve a large amount of capital. Cryptocurrency can be extremely volatile, and you should tread with caution before you invest in derivatives.

Frequently Asked Questions (FAQs)