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Here is why crypto derivatives are gaining traction

Edwin Munyui
Content
March 31, 2021

Drixx - Here is why crypto derivatives are gaining traction

The crypto market is proving to be one of the most profitable niches - it is well over $1.8 trillion as of press date, with Bitcoin taking up the lion's share at a 60% market dominance. Well, it now seems that derivatives are gaining popularity as this young ecosystem evolves to accommodate all types of market players. Unsurprisingly, institutional investors are also making a debut into crypto derivatives for a piece of the cake!

So, what's making these speculative assets very popular amongst crypto stakeholders? At the very core, it is their value proposition. Before we dig deeper, it would be important to understand what crypto derivatives are, how they work and the various types - the underlying fundamentals are featured in an earlier article published on our academy. That said, they are speculative instruments that allow traders and investors to gain exposure to a crypto asset, without necessarily buying or holding it.

Take the example of Bitcoin derivatives, their value is determined by BTC as the underlying asset. This simply means that those who purchase such an instrument will be getting indirect exposure to Bitcoin's price movement. That being the case, you only have to buy the derivative contract instead of buying BTC as an asset. These contracts are structured in different styles, depending on their types - more details are highlighted in the introduction article.

Having broken down the fundamental concepts, we can dive into the value proposition of crypto derivatives to get a better gist of this upcoming niche. The next sections will feature some of the uses, a comparison with the spot market, and the risks involved in trading crypto derivatives.

The Cutting edge in crypto derivatives

Just like in traditional markets, derivatives in the crypto space provide participants with an array of options for diversification and risk management. Other areas where these instruments have proven valuable include profit maximization and short-term exposure to crypto assets.

Diversification

With derivatives now available in the crypto market, it is much easier for traders and investors to diversify their digital asset holdings. These instruments have emerged as a means to trade cryptocurrencies like Bitcoin and Ether, without the need to buy the actual assets on spot markets. Today, you can get exposure to Bitcoin derivatives through crypto exchanges such as Drixx, where we offer both futures and options.

It is quite noteworthy that there are various ways in which you can achieve a diversified crypto portfolio through derivatives. While this should not be taken as financial advice, some of the simplest ways is by trading crypto futures. These are simply derivative contracts where the buyer has the right and obligation to act on it upon maturity - either buy or sell the underlying, depending on their position.

Futures are just but the tip of the iceberg, other derivative instruments such as options and perpetual swaps have also found their way into the crypto market. Options give their holders a right, but no obligation to act on the contract upon maturity. In short, they offer more flexibility in creating a hedged portfolio. Perpetual swaps on the other hand have no expiry dates - they allow traders to hold long/short positions for as long as they like.

Risk Management

As mentioned earlier, derivatives offer more alternatives for risk management strategies - both in traditional markets and crypto. Their debut in the latter ecosystem has brought a lot of change since the days when the most crypto trading activity took place in spot markets. We are now seeing a situation where stakeholders are taking advantage of these instruments to build more risk-informed portfolios.

Before their introduction, the only option was to hold your crypto assets in spot wallets while accommodating all the volatility that comes with the crypto market. This is no longer the case - crypto market participants can use available derivatives to build risk-neutral portfolios, or reduce their volatility exposure.

Take, for instance, a trader who wants to sell their BTC in six months, but expects the prices will have gone down. To hedge for this risk, they can simply buy a futures contract that gives them the right and obligation to sell their BTC at a predicted price as opposed to the prevailing market price at expiry. Should Bitcoin's price happen to drop, this trader will still sell their coins at a higher price than what the market will be offering.

Profit Maximization

While there are many opportunities to earn an income within the crypto ecosystem, some have shown more potential than others - however, the levels of risk also vary similarly. Crypto derivatives are among the instruments that currently present significant income opportunities for traders in this market. More importantly, the ability to amplify your returns through leverage - on Drixx, this could go up to 100X for both BTC and ETH futures.

With such huge amounts of leverage, crypto derivative traders have an opportunity to maximize their profits. Also, they can switch positions or sell their contracts before expiry dates to cash out early or minimize their losses - of course, this comes with a higher risk exposure compared to holding your crypto in spot wallets.

Derivatives vs Spot

Spot and derivative markets have several differences in their technical and fundamental aspects. Here are some of these variations:

Leverage

In spot markets, participants must own the asset they intend to get exposed to - this means that one has to buy a crypto asset like BTC or ETH on spot exchanges if they are looking to take a position. Unlike derivatives where traders can access leverage, the purchasing power in spot markets is also limited to one's initial capital. Ideally, a derivatives trader with $10 is better off than a spot trader with $10 - the former can take up 100X leverage to start trading with $1000.

Market Strategies

As we have seen, derivatives offer more market strategies than spot markets. Trading these speculative instruments provide multiple scenarios where one could be profitable or remain at their portfolio value, per their trading strategy. On the contrary, spot markets do not facilitate such flexibility - participants have limited strategies to diversify or hedge their risks. That being the case, derivatives are the go-to-market instruments for most sophisticated traders in traditional markets and crypto as well.

Liquidity

In general, derivatives are more liquid than spot markets because of the high leverages offered to trade these instruments. Such amounts of leverage make it possible for traders to place large orders with minimal collateral or initial capital. Recent months have seen crypto derivatives play a significant role in the price action of the market - larger fluctuations are often witnessed towards the end of a quarter (when most contracts expire). Going by the traction, crypto derivatives are likely to set the stage for a more mature market where speculative tools inform price action.

Challenges in crypto derivatives trading

High Risk

Trading crypto derivatives is highly risky and could result in the loss of one's capital in a matter of minutes - this level of risk comes from the high leverage that traders can access to enter speculative positions. A trader with 100X leverage is more likely to be liquidated (lose capital) than a counterpart with 10X, should the price of an underlying asset move against their favor.

Regulatory Uncertainty

Each jurisdiction in the world operates under its laws that recognize the legitimacy of operations in various sectors. Derivatives pose a regulatory risk in some jurisdictions like the U.S where financial watchdogs are particularly keen on consumer protection. This is a big challenge to the crypto derivatives market - no wonder most shops have set up outside the U.S and limit their services to avoid legal issues.

Counterparty risk

This is the risk that a counterparty could default or fail to honor their obligation when a derivative contract expires. It is especially likely in the case of over-the-counter (OTC) derivatives where traders have limited resources to carry out due diligence on their counterparties.

Summary

Derivatives are a fundamental part of both traditional markets emerging one's like crypto. These financial instruments have long been the solution to diversification and risk management strategies. While they may seem a little bit sophisticated, their liquid nature suggests that they are a favorite to the advanced/sophisticated market players - nonetheless, they are still considered as some of the riskiest assets in today's markets.

Disclaimer: The information presented here is for educational purposes only and should not be construed as investment advice. Cryptocurrency trading involves high risk. Drixx will always strive to do it’s best in educating customers and providing high quality products but will not be held responsible for their trading and investment decisions, losses or profits.