Derivatives are financial market instruments whose value is determined by an underlying asset. Essentially, derivative contracts are designed as market speculation instruments - they enable traders and investors to bet on the future of asset prices. These contracts can be pegged to various financial assets which include commodities, currencies, indexes, bonds, interest payments or cryptocurrencies.
Over the years, derivatives have gained traction in the traditional markets and are now emerging as a powerhouse in crypto as well. While most traders find them sophisticated, they have proven to be a fundamental part of the financial markets. Derivatives function quite differently from spot markets - they are basically speculation tools.
Unlike spot markets where the settlement happens real-time, derivative contracts are settled at a future date. This simply means that derivative traders realize the value of their contracts on the expiration date. However, it is not the case for all types of derivatives - some are designed to be settled on a daily basis or even shorter time frames.
That said, let's take a deeper look into the various types of derivatives, how they operate and their value proposition in the financial market.
Forwards and futures are derivative contracts that are settled on a later date - they allow two counter-parties to speculate on the prices of an underlying asset. Basically, traders do not have to buy the actual commodities; instead, they trade a representation of their value through forward and futures contracts.
The price of a forward or futures contract is agreed upon at contract initiation, although settlement takes place on the expiration date. In most futures markets, this settlement is made in cash or easily transferable financial products. However, traditional futures markets still run physically-settled derivative markets, where expired contracts are delivered in commodity form.
The futures market dates back to the 17th century when primitive markets emerged in Europe - Japan later debuted the Dojima rice exchange as the first futures market. At the time, rice was a popular means of payment in Japan, hence the need to hedge against its price volatility. This was actually the main value proposition of the derivative market.
To get a better picture of how it works, let's say John wants to buy a farm produce such as wheat at a later date. He is betting that the price of wheat will have gone up by then - John can hedge against this move by purchasing a forward or futures contract which quotes a lower price than his speculative figure. Upon expiry, John will be in profit if the price of wheat would have gone up and vice versa.
This is because in the first scenario he will purchase the wheat at a lower price compared to the prevailing market price, while in the second scenario he purchases the wheat at a higher price. Notably, forward and futures contract owners have the right and obligation to exercise the contracts upon maturity - this means that they have to settle as per the agreed prices on contract initiation.
While both forward and futures contracts have the same structure, the latter is more standardized when it comes to legal agreements and trading venues. Futures are customized to follow a set of rules which may feature specifics like the contract size and clearing venues. On the bright side, they have a lower counter-party risk compared to forward contracts.
(Also known as Cryptocurrency Perpetuals or Perpetual Swaps)
Perpetual contracts are an advanced type of futures that is specific to the cryptocurrency market - they don't have expiry dates. With perpetual contracts, traders can hold their long or short positions for as long as they wish. These derivative instruments eliminate the trading barrier of predetermined settlement dates, making the market more active for buyers and sellers.
One of the defining fundamentals of perpetual contracts is that they are traded based on an underlying index. This index typically consists of the average price of an asset, as per the spot markets and its relative trading volume. For instance, a BTC perpetual index would be based on the average price of BTC according to the pricing on major spot exchanges and their relative trading volume.
Unlike normal futures, perpetual contracts are settled at prices that are almost similar or equal to the prevailing spot prices. Buyers and sellers in this market pay regular payments that are dubbed the 'funding rate'. Basically, this is the settlement that a perpetual contract trader has to pay when the funding rate deviates from zero.
Long positions (contract buyers) are obligated to pay short positions (contract sellers) when the funding rate is above zero. Inversely, contract sellers have to pay contract buyers when the funding rate is negative. The funding rate is made up of two metrics: a premium and interest rate. The premium varies according to the pricing difference between futures and spot markets while the interest rate is set by exchanges.
Simply put, a perpetual futures contract that's trading on a premium (higher than spot) means that long positions have to pay the shorts - this is because of the positive funding rate. It is such pricing mechanics and the flexibility of perpetual contracts that eventually balance out the price of an underlying asset. Contract buyers can close their positions and open short positions or vice versa.
You might also want to check out inverse perpetual contracts, a special case of perpetuals.
Option contracts are derivatives that give traders the right but not obligation to buy or sell an asset at a predetermined price, before or on a specific date. Unlike forward and futures, options have the flexibility of not exercising the contract upon expiry. Instead, the option holder could choose to forego the premium at which they bought the contract.
There are two types of options: calls and puts. Call options give holders the right to buy an underlying asset while their put cousins give the right to sell. Consequently, traders buy call options when they expect the price of an underlying asset to increase - this exposes them to the probability of buying the asset at a cheaper price, before or on the expiry date of the contract.
On the other hand, put options are used by market participants to hedge against downward price movements. For example, a farmer who sells corn speculates that the price will have gone down in six months. They can buy a put option whose strike price is higher that the anticipated price. Assuming the market tanks indeed, the farmer will still sell their corn at a higher price than what they would have sold on spot.
The beauty about option contracts is that traders do not have to exercise the contract, should the spot markets provide a better offer. In such cases, premium is foregone and the trader buys or sells the underlying asset according to spot market prices. Clearly, option contracts have more room for flexibility compared to forwards and futures. Notably, this flexibility does not apply to both parties in the options contract agreement. Buyers have the upper hand since they can choose to exercise the contract or not - sellers (writers) depend on this decision.
Option contracts are defined by four major components which include the premium, strike price, expiration date and the size. The premium is basically the prize of the options contract while the strike price is the predetermined buy or sell price of the underlying asset. As the name suggests, expiration date is when the option contract becomes invalid, and size is the quantity of contracts to be traded.
Hedging and Risk Management Strategies: Derivative instruments are good market tools for creating strategies to hedge and manage risk. Take for instance, the farmer who wanted to hedge against a downward price movement in corn - with derivatives, they can create a strategy to hedge against this uncertainty.
Asset Diversification: Derivatives expose traders to assets that would have otherwise been cumbersome to buy on spot. Some of the commodities featured in traditional derivative markets include oil and gold amongst other valuable physical assets. The emergence of derivatives has helped traders and investors to acquire an exposure in these commodities.
Profit maximization on leverage: Most derivative contracts allow traders to borrow/leverage their positions depending on the collateral amount. Some derivative markets provide up to 100X leverage which means that if trader A deposits $10, their trading position could be leveraged to increase up to $1000. Automatically, they are in a position to make more profits than they would have with only the initial deposit.
Short exposure: Derivatives enable investors or traders to exchange an underlying asset without actually owning the asset - this is referred to as a 'naked' position. Basically, derivative contracts can be bought or sold according to their value as opposed to trading the actual asset.
Derivatives are definitely a fundamental part of the financial ecosystem - these instruments are likely to grow more liquid as time goes by. No wonder they have begun making in-roads into the crypto market. Today, billions worth of crypto derivatives are traded in this nascent ecosystem - a trend that is catching up with both retail and institutional investors.
Nonetheless, their complex nature is still overwhelming to the new market entrants and some veterans as well. While it may take some time to understand and practice the actual concept, the value proposition of derivatives in financial markets cannot be overlooked by any serious stakeholder. Going forward, this market will likely spread out to feature more underlying assets.