Key takeaways
- Derivative markets for cryptocurrency involve contracts between a buyer and a seller to trade an asset at a pre-agreed price on a specific date. This gives traders the ability to profit between the contract and the underlying market price difference.
- Advanced crypto trading strategies regularly use futures, options and perpetual contracts to take advantage of leverage and depressed markets and to hedge risk against spot trades.
- Futures contracts obligate a buyer and seller to trade at contract expiry, while options contracts only give the option to buy. Perpetuals are similar to futures but have no explicit expiry date.
- Volatility in crypto derivatives can be taken advantage of to speculate on future price movements while enjoying low fees and avoiding the burden of direct asset ownership.
Cryptocurrency trading has become highly sophisticated over the last decade. Many of the leading exchanges have introduced complex financial products inspired by traditional finance. Crypto derivatives are now commonplace in the market.
Often, exchanges list them for trading before the underlying asset. Plus, there are dedicated derivatives platforms where you can’t even trade the actual crypto coins and tokens.
If you’re new to derivative trading, then keep reading this simple crypto derivatives 101 guide. By the end, you’ll have a clear understanding of futures, options and perpetuals in crypto and how they work.
What are crypto derivatives
Derivatives are a financial contract between two traders: one buyer and one seller. The contracts either oblige or offer the option to trade an asset at a predetermined price on a specific date.
Let’s understand the concept via a simplified example:
Two parties agree to trade one Bitcoin (BTC) for $70,000 on Nov. 30, 2024. On this expiry date, the buyer must buy, and the seller must sell at this price. It doesn’t matter what the price of Bitcoin is trading for on the spot market.
The difference between the contract price and the actual price is where the profit and loss is made. These contracts can be bought and sold during their lifetime for traders to try and profit or reduce risk.
There are numerous types of crypto derivative contracts, but they generally have the same main components:
- Underlying asset: This is the cryptocurrency on which the contract is based. It is the crypto that is agreed upon to be bought or sold at the predetermined price. This could be any crypto from Ethereum (ETH) to Solana (SOL) to Dogecoin (DOGE).
- Quantity: The amount of the underlying asset that will be traded as per the contract. It could be one unit,100 or thousands of a particular crypto.
- Settlement date: The predetermined date on which the contract will be exercised and the underlying asset is bought and sold.
- Method of delivery: This is how the trade is paid out. It could be a trade of the underlying asset or cash-settled equivalent where the contracts are executed using fiat currencies or stablecoins. Cash settlement is most common with crypto derivatives trading rather than trading the actual underlying asset.
Did you know? The first crypto derivatives exchange launched in 2012, just three years after Bitcoin’s invention. It sparked interest in this style of trading and paved the way for a more user-friendly platform, BitMEX, to launch in 2014. Notably, BitMEX went on to invent the perpetual swap contract, which now dominates the market.
How crypto derivatives work: Futures, options and perpetuals
As you can imagine, derivatives and their different types can get complicated. Still, in many ways, they are simple and allow investors to bet and speculate on the future prices of a cryptocurrency.
Let’s take a look at the main types of derivatives, their terminology, and how they work.
Crypto futures
A crypto future is a type of derivative contract allowing you to bet on the future price of a specific cryptocurrency. It is a contract that specifies how much the underlying asset will be bought/sold for on a specific date.
To initiate a contract, the buyer and seller agree on a price and expiry date for the trade to be settled. A futures investor can take either long or short positions on the contract. A long position means a trader believes an asset price will rise above the agreed futures contract price.
If correct, the trader could buy the asset for below market value at the time of expiration. Then, immediately sell the asset for a profit at the higher market price. Alternatively, you could take a short position with the aim of selling the futures contract before expiration, expecting its price to drop in value.
During a futures contract, long and short traders can close their positions. For a long trade, you would sell the futures contract onward. For a short trade, you would buy back the underlying asset.
If it sounds like there’s always a winner and a loser, then you’re right. Future trading is a zero-sum product. The difference in the contract price and the market price of the asset at expiration locks in either profit or loss for each side of the trade.
Let’s understand how crypto futures work with an example:
Suppose Bitcoin is currently priced at $72,000. You enter a futures contract to buy Bitcoin at $72,500 in one month.
- If Bitcoin reaches $75,000: You profit by buying at $72,500 and selling at the market rate of $75,000. Your gain is $2,500.
- If Bitcoin drops to $70,000: You’re still required to buy at $72,500, resulting in a $2,500 loss.
- If Bitcoin stays around $72,500: You break even.
Crypto options trading
Options are similar to futures contracts but give buyers the right or “option” to buy an asset, not a contractual obligation to buy or sell at a specific price. That’s the main difference between crypto options vs futures.
There are two main types of options contracts:
- American or “anytime”: Buyers can exercise their right at any time before expiry.
- European or “point of expiration”: The option can only be taken at the date and time of contract expiration.
Many traders prefer option contracts as there is no commitment for a buyer to purchase and a seller to sell if their position becomes unprofitable. In options trading, the right to buy is referred to as a call option. The right to sell is known as a put option.
Options contracts are created with the following:
- Strike price: The predetermined price for an option to be bought or sold before expiry. A key factor in determining its potential profitability.
- Termination date: The specified time when the option to buy or sell ends.
- Premium: The fee an investor must pay to buy an options contract for the right to buy or sell an asset at a predetermined price.
As a buyer can choose to exercise the option or not, they must pay a fee to the seller called a premium. It works as compensation for the seller if the contract is left to experience. Without a premium, anyone could enter an options contract without needing any funds, and there would be no incentive for sellers to create options contracts.
So, it works in the seller’s favor for the contract to expire without the option to buy being taken, as they would collect the premium without selling the asset.
Let’s understand how crypto options work with an example:
Imagine you buy a call option on Bitcoin with a strike price of $72,500, paying a $500 premium for the right to buy it within the month.
- If Bitcoin goes up to $75,000: You exercise the option and buy Bitcoin at $72,500, netting a $2,000 profit after subtracting the $500 premium.
- If Bitcoin drops to $70,000: You let the option expire, losing only your $500 premium since you’re not obligated to buy.
- If Bitcoin stays at $72,500: You break even on the strike price, but you still lose the $500 premium paid.
Crypto perpetual contracts
Crypto perpetual contracts are very similar to normal futures contracts, except they have no expiry date. They are never-ending or “perpetual” and also referred to as perps or perpetual swaps. Once again, they enable people to bet on the future price of assets.
Similar to futures, it is a zero-sum trade, either profitable or unprofitable. Still, traders can keep the contract open as long as they want; usually, this results in the contracts being bought and sold indefinitely. So, they are “swapped” often rather than traders exercising the right to buy or sell the underlying asset.
The other difference is that perpetual swaps in crypto more closely track the market price of the underlying asset. This is because they can be exercised more readily. These derivatives have what’s called a funding rate. This is a mechanism to keep the contract value in line with the underlying asset value.
The system means the long position holder must pay a fee to the short position holder or vice-versa. This is the fee you pay during your bet that market prices will move in your favor.
Let’s understand how crypto perpetual contracts work with an example:
Suppose you enter a perpetual contract to buy Bitcoin at $72,000 with no expiration.
- If Bitcoin rises to $75,000: You profit $3,000 from the increase, minus any funding fees.
- If Bitcoin drops to $70,000: You incur a $2,000 loss. The contract continues, but losses accumulate as long as the price remains below $72,000.
- If Bitcoin stays near $72,000: You hold a neutral position, paying only periodic funding fees.
Did you know? The crypto derivatives market regularly records 24-hour trading volumes of over $500 billion as traders look to profit from market volatility.
Why use crypto derivatives?
You might think, why bother with derivatives when you can just buy the actual cryptocurrency? After all, if you believe it will go up in value, then all you have to do is buy and hodl.
Here are the advantages of crypto derivatives:
- Speculation: Trading derivatives allows you to bet on the future price of cryptocurrencies. You can take advantage of price swings in both directions. If you’re confident an asset will fall in value, you can open a short position. Or, if you think the market will go up, you can take a long position to profit from the difference in your derivative contract compared to the asset price.
- No asset ownership: You are trading financial contracts that provide exposure to a particular cryptocurrency rather than the actual coin or token itself. You can profit without worrying about custody of the underlying asset — no need for wallets or private keys.
- Fees: Usually, fees for futures trading are lower than spot trading fees. Most major crypto exchanges like Binance and Kraken offer fee structures as low as 0.01%
- Hedging: If you own and trade spot cryptocurrencies, derivatives can be used for risk management in crypto trading. Commonly, this involves hedging against falling prices. It protects you and helps you profit in downward markets without having to sell the underlying cryptocurrencies you hold.
- Leverage: Derivative products and exchanges offer margin trading in crypto. This allows you to borrow funds to increase your trade size. Some platforms provide leverage of up to 100 times. It quickly amplifies profits when you’re in the money. But losses can rack up just as quickly, leading to liquidation of your trades when using leverage in crypto derivatives.
Did you know? Bitcoin derivative trends often drive underlying spot market prices. Bullish derivative trends deliver positive market sentiment and confidence to spot investors. Plus, it can work in reverse as traders bet against the market.
Risks associated with crypto derivatives
Trading cryptocurrency derivatives can be highly lucrative but also involves significant risks.
Here are some of the key risks associated with crypto derivatives trading:
Leverage risks
Derivatives trading, especially with high leverage, allows traders to control large positions with a small amount of capital.
While this can amplify gains, it also magnifies losses, potentially leading to losses that exceed the initial investment. A small market move against a leveraged position can result in significant losses or even a total loss of capital.
Market volatility
Cryptocurrencies are notoriously volatile, with price swings of 10% or more in a single day. This volatility can make derivatives positions highly unpredictable, causing traders to face sudden liquidation of positions or requiring additional capital to maintain margin levels.
In leveraged trades, these rapid price changes can also cause slippage, further complicating risk management.
Counterparty risk
When trading on derivatives exchanges, there is always the risk that the counterparty (the exchange itself) may face insolvency or operational issues. If an exchange fails or is hacked, users may lose their funds.
Some derivatives platforms have insurance funds to protect against such events, but coverage may be limited.
Liquidity risk
Unlike spot trading, derivative markets may have less liquidity, especially for more niche or exotic cryptocurrency pairs.
Low liquidity can make it difficult to enter or exit positions at desired prices, leading to slippage and potentially forcing traders to settle at a loss or wait longer than anticipated to fill orders.
Regulatory risks
Cryptocurrency derivatives trading is subject to regulatory scrutiny and can be banned or restricted in certain jurisdictions.
Changing regulations may limit access to platforms, impose heavy compliance costs or lead to sudden platform shutdowns, leaving traders without access to their positions.
Complexity and knowledge risk
Crypto derivatives are complex financial instruments that often require advanced understanding to manage effectively.
Derivative products like futures, options, and perpetual swaps come with unique terms and conditions, such as expiration dates, funding rates and margin requirements. A lack of knowledge about these factors can lead to mismanagement of trades and unintentional losses.
Funding rate risks in perpetual swaps
In perpetual futures trading, funding rates are used to maintain price equilibrium with the underlying asset. These rates fluctuate based on supply and demand, meaning traders can face unexpected fees.
If funding rates spike, traders may need to pay substantial amounts just to maintain their positions.
Technology and platform risks
Trading derivatives on digital platforms comes with the risk of technical issues, such as system downtime, trading lags or glitches.
High-frequency traders, for instance, rely on uninterrupted data streams, and disruptions can result in missed opportunities, forced liquidations or unfavorable trades.
Psychological risks
The high stakes and fast pace of derivatives trading can create a highly stressful environment.
Emotional trading, induced by fear of missing out (FOMO) or panic, can lead to poor decision-making and impulsive trades that deviate from one’s trading strategy, resulting in increased losses.
Collateral risk in cross-margining
In derivatives trading, cross-margining allows the collateral for one position to be used to cover another.
While this can optimize capital efficiency, it also exposes a trader’s entire portfolio to risk. A substantial loss in one position can force liquidations across multiple positions, leading to compounded losses.
Therefore, risk management in crypto trading is necessary, which involves setting clear strategies to minimize potential losses, including using stop-loss orders, position sizing and diversification.
Staying updated on market trends, limiting leverage and establishing emotional control are key. Proper risk management helps preserve capital, reduce exposure to volatility and build long-term trading resilience.