In 2020, the global derivatives market was estimated at $1 quadrillion (that’s 10X the world’s gross domestic product or 3X the estimated value of all global wealth!) The crypto derivatives market is still in its infancy, but it’s growing fast.
What are derivatives?
Derivatives are complex financial instruments whose value is derived from an underlying asset. Derivatives’ are based on the future price of the asset, traders use them as a means of speculation or to hedge (protect against) risk. They are commonly used by investors, governments and corporations to minimise their risk exposure.
Derivatives is an umbrella term, but there are two main types in crypto:
- A futures contract is the obligation to buy an underlying asset, e.g. ETH, at a set point in the future, at a defined price.
- An options contract is similar. It is the right to buy or sell an asset at a set time in the future, at a defined price; however, the holder is not obligated to do so.
Futures & perpetual futures
Futures themselves aren’t used all that much in crypto, it’s perpetual futures that are the most popular derivative in crypto by a long way. These are what you see offered on many crypto exchanges.
A future is an agreement to purchase an asset (such as Bitcoin) at a set time in the future. A future defines the number of units of the particular asset that will be bought as well as the price, and time at which it will be purchased. At the expiration date, the holder of the future is obligated to buy the asset for the previously agreed price.
Unlike crypto futures, which have a limited lifespan, perpetual futures do not have an expiration date. They are cash-settled, meaning no need to send over your assets when you settle.
There is a growing range of options products on the crypto market. An Option (or Options Contract) gives the holder the right or choice to buy (or sell) an asset at a set time in the future for a fixed price. This differs from a futures contract as there’s no obligation to buy.
The holder of option must pay a premium to be granted the choice to purchase the asset in the future. This is charged on purchase of the contract.
The price at which the asset will be bought (or sold) should the contract holder choose to do so is known as the strike price. In the case of a buy option, if the strike price is below the market price, the investor can purchase the asset at a discount and (taking the premium into account) exercise the contract to make a profit. However, if the strike price is higher than the market price, the holder has no reason to complete the contract. If the contract is not exercised, the holder will lose the premium paid.
Note that options are highly complex and involve high risk, especially if the investor doesn’t understand the working mechanisms.
Read more about derivatives here.
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