Guide To Crypto Derivatives

GUIDE TO CRYPTO DERIVATIVES: WHAT IS
CRYPTOCURRENCY DERIVATIVES?
BY AZIZ, MASTER THE CRYPTO FOUNDER
This guide to crypto derivatives takes an introductory look into an interesting

development, tackling a core question on what is cryptocurrency derivatives.
OVERVIEW
The cryptocurrency market has blossomed into a diverse ecosystem of over
2,000 coins and tokens, with each of them focusing on a specific type of
application and use case that is built using the revolutionary blockchain
technology. Though the infrastructure supporting the cryptocurrency world is
still in its early stages, there are various developments that would warrant
greater exposure and awareness of cryptocurrencies. One such advancement
is the introduction of a cryptocurrency derivatives, which is a brand-new line of
financial products. The most common form of cryptcurrency derivatives at the
moment is Bitcoin futures, which received a mixed reaction among the
community.
The popularity of Bitcoin futures is apparent when we look at the average

trading daily volume, which has seen an increase of more than 40% in the
third quarter of 2017. In monetary terms, the average daily volume of Bitcoin
futures stood at 5,053 contracts, with a cumulative value of approximately
$177 million. This data is pretty impressive, especially if we take into
consideration that the cryptocurrency market has been in a recession since
the start of 2018, where the general prices of coins and tokens have
plummeted by more than 85%!
(Source: Investopedia)
Greater trading volume is an indication of good liquidity, which is always a

good thing for market participants. This reflects a growing and healthy
marketplace.
(Read more: How Will Bitcoin Futures Affect Bitcoin Prices? Here’s What
History Says)
WHAT ARE CRYPTO DERIVATIVES?

Before we move on, let’s try to understand the universe of cryptocurrency
derivatives.
A derivative is simply a financial contract between two or more parties that

derives (hence ‘derivatives’) its value from an underlying asset, in this case,
cryptocurrencies. More specifically, it is an agreement to buy or sell a
particular asset – be it stocks or cryptocurrencies – at a predetermined price
and a specified time in the future.
Derivatives do not have inherent or direct value by themselves; the value of a

derivative contract is purely based on the expected future price movements of
the underlying cryptocurrency.
There are 3 common types of derivatives product in the financial world:

The three main forms of derivatives are:
 Swaps: A swap is an arrangement between 2 parties to exchange a

series of cash flows in the future, usually based on interest-bearing
instruments such as loans, bonds or notes as the underlying asset. The
most common form of swaps are interest swaps., which involves the
exchange of a future stream of fixed interest rate payments for a
stream of floating rate payments between 2 different counter-parties.
 Futures: A financial contract where a buyer has an obligation for a
buyer to purchase an asset or a seller to sell an asset (such as
commodities) at a fixed price and a predetermined future price.
 Options: A financial contract where a buyer has the right (not an
obligation) to purchase an asset or a seller to sell an asset at a pre-
determined price by a specific timeline.
Due to the infancy of the cryptocurrency derivatives market, there is only a few
derivatives products available for the public at the moment. The most common
cryptocurrency derivatives are Bitcoin futures and options, due to the fact
that Bitcoin controls over 50% of the entire cryptocurrency market
capitalization, making it the largest and most-traded coin around.
(See also: Will A Crash in Bitcoin’s Price Lead to Its Demise?)
REASONS FOR TRADING DERIVATIVES

Derivatives are highly complex financial instruments that is used by advanced
or technical investors. There are two main reasons for the use of derivatives,
which include:
1. PROTECTION FROM VOLATILITY
The fundamental reason for the existence of derivatives is for individuals and
corporations to reduce their risk exposure and protect themselves from
any fluctuations in the price of the underlying asset. Here’s a real-life example
that explains how derivatives are used to offset risks:
Imagine if you’ve decided to get a cable TV subscription to watch your favorite

channels. As a buyer of the service, you will enter into a fixed agreement with
the cable company to allow you to get a specified number of channels at a
monthly fixed price for a period of 1-year. This is similar to a futures contract,
where you specify the exact price that you’re going to pay and the exact
product/services you’re going to receive within the specified period of 1-year.
In other words, you have secured the monthly pricing of cable TV channels for
a full year, knowing full well that you’re going to pay a fixed price no matter
what, even if the price for cable TV rises during the year. By entering into this
agreement, you reduce your risk of having to pay a higher monthly price
throughout the year.
This is how derivatives work, except instead of cable TV, a rice farmer may be
trying to secure sales of next season’s produce. Since the price of rice
fluctuates on a daily basis depending on market conditions, the rice farmer
would be keen to fix the price the next year’s harvest so that he would be
protected from the volatility of daily price fluctuations. Businesses would also
need to use derivatives to reduce their risk exposure. A bakery trying to buy
wheat flour from a farmer would use a derivative contract to ‘lock-in’ the price
of wheat flour for the year. This ensures that the bakery business can forecast
its budget for the business year and protect itself from the fluctuations of
wheat prices. It is these derivatives contracts between a buyer and seller that
can be traded in the derivatives market.
(Read also: Guide on Identifying Scam Coins)
2. HEDGING (INSURANCE POLICY)
Investors could also use derivatives to protect their investment portfolio. This
is also called ‘hedging’, which entails taking measures to offset potential
losses. Derivatives serve as a vital risk management technique for institutions
and investors. The concept of hedging is similar to owning an insurance policy
for your portfolio. Here is an example to illustrate a hedging scenario:
Assume that you are bullish on Apple (AAPL) and owns a significant amount
of AAPL stocks. However, there is a tremendous amount of risk that you’re
holding; if the American economy suffered from a systemic shock or bad
news, you can be sure that AAPL prices would tumble and reduce your
investment capital. You can use derivatives – in the form of options contracts
– to reduce your overall investment risk. Using a type of options called ‘put
options’, you can profit from your options contract since they will increase in
value when prices of the underlying asset (in this case AAPL stocks) goes
down.
So, if you own AAPL stocks and are worried about the unforeseen
circumstances that can adversely affect your portfolio, you can buy derivatives
to protect your investments and offset the potential losses. Although the main
value of your AAPL investments drops in value, the increase in the value of
your put option derivatives will offset the overall loss. Depending on factors
such as experience and expertise in derivatives, an investor or trader could be
profitable in any situation, be it a bull or bear market.
Hedging could save you from potential headaches or worries that you might
face in your investing journey. Having an insurance policy by using derivatives
ensures that you manage your risks well and more importantly, allows you to
have a good night’s sleep!
(See more: Cryptocurrencies: A New Asset Class for Institutional Investors?)
3. SPECULATION
Traders often utilize derivatives to speculate on the prices of cryptocurrencies,

with the main objective of profiting from the changes in the price of the
underlying cryptocurrency. For instance, a trader might attempt to profit from
an anticipated drop in the general prices of cryptocurrencies by ‘shorting’ the
coin. Shorting – or short-selling – refers to the act of betting against the price
of a security. Speculation is often viewed negatively since it adds a higher
degree of volatility to the overall marketplace.
Traditionally, the way to profit from cryptocurrencies – or any securities for that
matter – is to buy a coin at a low price and sell at a higher price later.
However, this can only be done in a bull market, or when the market is
trending upwards. Shorting is a way to profit from a bear market, or when the
market is in a downtrend.
The easiest way to ‘short’ is for you to borrow a security from a third party (an
exchange or broker) and sell it immediately in the market since you expect
prices to fall. You can re-enter the market once prices have fallen and buy
back the same amount of securities that you initially sold. Thereby settling
your account with the third parties. In this case, you will profit from selling the
securities initially and buying them back at lower prices.
An easier way to short is by using derivatives contract since it is much

cheaper and ‘capital efficient’. If anyone thinks that the prices of a
cryptocurrency is unsustainable or would be experiencing a downtrend soon,
they could sell derivative contracts in the open market to anyone who thinks
otherwise (that the market is going to go upwards).
Read more: Crypto Beginners Guide: 5 Things Crypto Newbies Should Know)
SPOT MARKET VS DERIVATIVES MARKET

There are generally two kinds of markets in the cryptocurrency world; the spot
market and the derivatives market. Both have their own unique characteristics,
which can be shown here:
The spot market (or the ‘cash’ market) refers to the exchange and settlement
of financial assets – such as stocks and cryptocurrencies – immediately.
This means that the ownership of cryptocurrencies is immediately transferred
between market participants (from a seller to a buyer) instantly after the
transactions are executed. When you go to an exchange to purchase any
cryptocurrency, you are participating in the spot market since the transaction
occurs on the ’spot’ and you will own the coins that you purchased
immediately.
The derivatives market is where participants trade contracts instead of the

actual asset itself. These contracts possess value, which is directly tied to the
underlying asset. Therefore, derivatives are financial instruments rather than
an asset.
(See more: Evolution of Cryptocurrency: Replacing Modern Cash)
WHERE TO TRADE CRYPTO DERIVATIVES

LedgerX was the first regulated institutional exchange that
introduced Bitcoin derivatives, in the form of swaps and options. Only
accredited investors and institutional players can trade on LedgerX’s trading
platform.
Bitcoin futures were first introduced by Chicago Mercantile Exchange (CME)

and Chicago Board OptionsExchange (CBOE) on December 2017. Chicago
Mercantile Exchange (CME) is the world’s largest derivatives exchange,
handling over 20% of the total derivative trading volume globally. Retail
investors who are keen to trade CME’s Bitcoin futures can do so via an
associated vendor or broker listed here. The differences between CME and
CBOE derivatives are shown below:
In terms of derivatives offered by pure cryptocurrency
exchanges, Bitmex, OKEX and CryptoFacilities are the current major players.
It is important to note that the derivatives product offered by pure
cryptocurrency exchanges are not regulated by any jurisdiction at this
moment. This increases the risks associated with those derivatives. Here is a
comparison between cryptocurrency exchanges that offer derivatives:
Bakkt is a highly-anticipated cryptocurrency futures exchange that is backed
by Intercontinental Exchange (ICE), which is the 3rd largest exchange group in
the world, behind CME and Hong Kong Exchange. Not only is Bakkt owned by
the parent company of the New York Stock Exchange (NYSE), Bakkt is
supported by various heavyweights such as Microsoft, Starbucks and Pantera
Capital. Bakkt aims to offer Bitcoin futures by January 2019.
Another major player aiming to enter the derivatives space is Nasdaq, the
world’s second largest stock exchange. Nasdaq plans to roll out its Bitcoin
futures by the first quarter of 2019.
(Read also: Crypto Trading Guide: 4 Common Pitfalls Every Crypto Trader

Will Experience)
WORD OF CAUTION
Although derivatives was one of the core factors that contributed to the global
financial crisis back in 2007, it is still a vital tool in managing investment risks.
The market has been extremely excited for cryptocurrency-based derivatives
product since major traditional exchanges – CBOE and CME – launched
Bitcoin futures at the end of 2017. It is easy to see that the derivatives market
is needed for a vibrant financial ecosystem, and perhaps this is the bridge that
is needed to enhance the awareness of cryptocurrencies to the mass market.
However, caution must be exercised when dealing with derivatives given their
complexity and sophistication.
The next article will dive deeper into the technical details of how derivatives
actually work and the implications of using these complex financial products.
(You might also be interested in: Evolution of Cryptocurrency: The Problem

With Money Today)
BENEFICIAL RESOURCES TO GET YOU STARTED

If you're starting your journey into the complex world of cryptocurrencies,
here's a list of useful resources and guides that will get you on your way:
TRADING & EXCHANGE
 Crypto Guide 101: Choosing The Best Cryptocurrency Exchange

 Guide to Bittrex Exchange: How to Trade on Bittrex
 Guide to Binance Exchange: How to Open Binance Account and What
You Should Know
 Guide to Etherdelta Exchange: How to Trade on Etherdelta
 Guide To Cryptocurrency Trading Basics: Introduction to Crypto
Technical Analysis
 Cryptocurrency Trading: Understanding Cryptocurrency Trading Pairs &
How it Works
 Crypto Trading Guide: 4 Common Pitfalls Every Crypto Trader Will
Experience
WALLETS
 Guide to Cryptocurrency Wallets: Why Do You Need Wallets?

 Guide to Cryptocurrency Wallets: Opening a Bitcoin Wallet
 Guide to Cryptocurrency Wallets: Opening a MyEtherWallet (MEW)

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GUIDE TO CRYPTO DERIVATIVES: WHAT IS

This guide to crypto derivatives takes an introductory look into an interesting

The popularity of Bitcoin futures is apparent when we look at the average

Greater trading volume is an indication of good liquidity, which is always a

WHAT ARE CRYPTO DERIVATIVES?

A derivative is simply a financial contract between two or more parties that

Derivatives do not have inherent or direct value by themselves; the value of a

There are 3 common types of derivatives product in the financial world:

 Swaps: A swap is an arrangement between 2 parties to exchange a

(See also: Will A Crash in Bitcoin’s Price Lead to Its Demise?)

REASONS FOR TRADING DERIVATIVES

1. PROTECTION FROM VOLATILITY

Imagine if you’ve decided to get a cable TV subscription to watch your favorite

(Read also: Guide on Identifying Scam Coins)

2. HEDGING (INSURANCE POLICY)

Traders often utilize derivatives to speculate on the prices of cryptocurrencies,

An easier way to short is by using derivatives contract since it is much

Read more: Crypto Beginners Guide: 5 Things Crypto Newbies Should Know)

SPOT MARKET VS DERIVATIVES MARKET

The derivatives market is where participants trade contracts instead of the

(See more: Evolution of Cryptocurrency: Replacing Modern Cash)

WHERE TO TRADE CRYPTO DERIVATIVES

Bitcoin futures were first introduced by Chicago Mercantile Exchange (CME)

(Read also: Crypto Trading Guide: 4 Common Pitfalls Every Crypto Trader

(You might also be interested in: Evolution of Cryptocurrency: The Problem

BENEFICIAL RESOURCES TO GET YOU STARTED

 Crypto Guide 101: Choosing The Best Cryptocurrency Exchange

 Guide to Cryptocurrency Wallets: Why Do You Need Wallets?

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