Derivatives — What Are They and How to Profit from Them?

What are Crypto Derivatives and How to Use Them

Financial markets provide many tools for extracting profit. Derivatives are one of them, helping not only to generate income but also to hedge risks; however, this is only possible when the tool is used correctly. 

What derivatives are, what types exist, their advantages and disadvantages — read all about it in this article. 

Definition of Derivatives

Derivative financial instruments (derivatives) are agreements between parties to a transaction related to a specific underlying asset. Their value is derived from price changes of this asset, which explains the name. The terms of the contract define the rights and obligations of the parties regarding the transfer of a certain volume of the underlying asset. Key parameters, such as the asset's transfer price, may be fixed at the time of the deal, but the fulfillment of obligations usually occurs in the future.

Examples of Underlying Assets

Any asset traded on an exchange can serve as an underlying asset: 

• Currencies;

• Stocks; 

• Bonds; 

• Commodities; 

• Indices;

• Cryptocurrencies.

Types of Derivatives

Futures Contract

A futures or futures contract is derived from the word "future." It represents an agreement or contract with specified terms and price for an asset that must be bought or sold in the future. In fact, examples of futures contracts are very common in everyday life. For instance, you like a jacket in a store, but you don't have the money to buy it right now. You agree with the seller to leave a deposit and return with the remaining amount in a week. This is an example of a futures contract in daily life. 

There are two types of futures:

1. Deliverable — the physical asset is delivered for sale or purchase on the agreed date; 

2. Cash-settled — the physical asset is not delivered on the agreed date, and one of the parties pays the price difference. 

The example of the jacket is a deliverable futures contract. Let’s look at an example of a cash-settled futures contract. Suppose you want to sell a deliverable futures for an ounce of gold. Its current price is $3,000, you are satisfied with it, you agree with the buyer and write it into the contract. Then there are two scenarios: if by the expiration date the price per ounce of gold has risen to $3,150, you are obliged to pay the buyer a $150 premium. If the price becomes $2,850, then the buyer must pay you a $150 premium. 

Forward Contract

A forward contract is the same as a futures contract, with several differences: 

1. It is not available to individuals. Forward contracts are concluded between companies;  

2. Trading of forward contracts takes place in the over-the-counter (OTC) market, with its own regulatory rules. For this reason, it is harder to find a buyer or seller for this derivative than for a futures contract; 

3. The terms of forward contracts are always customized, without standard frameworks. 

Options

An option is a type of derivative financial instrument. It is a form of agreement between parties that gives the right, but not the obligation, to buy or sell an asset at a pre-agreed date and price. Upon reaching the agreed date, the option holder decides whether to exercise their right or not. 

Options are divided into two types: 

1. Call option — gives the holder the right to buy the underlying asset;

2. Put option — gives the holder the right to sell the underlying asset.

The day when the settlement for the option occurs is called the expiration date. The price at which the option must be executed is called the strike price. Options, like futures contracts, are also divided into deliverable and cash-settled. 

With deliverable options, it's simple: you bought a call option, if by the expiration day the price is higher than the strike, the holder uses their right and buys the underlying asset. Then the asset is sold at the current price, and the holder earns on the price difference. If the price is lower, the holder does not use their right and only pays the premium. The premium is the initial cost of the option. It depends on the probability of reaching the strike within a certain period, as well as the amount of the underlying asset that can be bought or sold.

With cash-settled options, the situation is slightly different: instead of physical delivery, the profit or loss is calculated based on the volatility of the asset and is called delta. Delta is a unit of measurement for the cost of the underlying asset. The delta indicator can be from 1 to -1 and is most often denoted as a percentage. The price of the option depends on the change in the value of the underlying asset, and delta interprets this correctly. Suppose the price of the underlying asset changed by $1, and the delta is 0.7 or 70% — this means that the value of the option will change by $0.70.

Swap

A swap is a temporary exchange of assets for the purpose of trading on exchanges or subsequent exchange. Parties can exchange any assets, but they undertake to return them after a certain time in the same form or in monetary equivalent. 

There are several types of swaps:

1. Interest rate swaps. A transaction in which two parties exchange interest payments on a pre-agreed amount. One party pays a fixed rate, and the other pays a floating rate;

2. Currency swaps. A combination of two currency operations: first a purchase, then a sale of currency (or vice versa) on different dates. Used for rolling over currency positions and hedging currency risks;

3. Equity swaps. A deal in which one party receives the return on a stock index and in return pays a fixed or floating interest rate. Helps investors gain returns from stocks they cannot invest in directly;

4. Commodity swaps. An exchange of payments based on commodity prices or commodity indices without physical delivery. Companies use these swaps to protect against price risks.

5. Credit default swaps (CDS). A financial instrument similar to insurance, where the buyer pays a premium and the seller assumes the risk of a third-party default. Used for hedging credit risks.

Pros and Cons of Derivatives

Advantages

1. Risks can be hedged using futures and options; 

2. The use of leverage can multiply profits; 

3. Derivatives allow for diversifying financial strategies due to their variety. 

Disadvantages

1. Leverage can provide super-profits but can also bring colossal losses; 

2. Sensitivity to market changes, which creates higher volatility than the underlying asset;

3. Legal vulnerability of OTC derivatives, often classified by law as wagers and lacking judicial protection.

History of Crypto Derivatives

The pioneer of derivative financial instruments in the world of cryptocurrencies was the well-known BitMEX exchange. It was the first to provide trading in cash-settled and perpetual futures for Bitcoin. For a long time, BitMEX managed to hold first place among exchanges trading crypto derivatives. But in 2019, the situation changed: the futures divisions of Binance and Huobi began gaining momentum, and two new exchanges appeared — Deribit and Bybit. 

Many members of the crypto community were waiting for the arrival of crypto derivatives, as they could facilitate the attraction of institutional investors to the market. One could even say that crypto derivatives were created exclusively for their attraction, and there were reasons for this:

• The crypto market was still quite young, continuing its formation and development every year. It is these factors that provide room for various scammers who slow down its development due to dishonest activities. Attracting institutional investors could mean that special, licensed platforms would be created, because they wouldn't bring their capital to regular crypto exchanges. The creation of these platforms would attract the attention of government regulators, who in turn would help rid the industry of scammers;

• With the help of crypto derivatives and institutional investors, the total trading volume of the cryptocurrency market was expected to grow. This means its volatility should decrease, saving market participants from sudden liquidations (squeezes).

Another fact that doesn't relate to institutionals — the existence of crypto derivatives allows market participants to trade the downside, which increases opportunities for profit. 

The arrival of institutional investors in the crypto market has occurred: the Bakkt platform has been providing deliverable Bitcoin futures since 2019, and the CME has been providing cash-settled Bitcoin futures since 2017. 

Conclusion

Derivatives are an integral part of financial markets, offering investors tools for risk hedging and speculative trading. In the cryptocurrency sector, they promote market development by attracting institutional investors and increasing liquidity. However, using derivative instruments requires a deep understanding of how they work, as high volatility and leverage can lead to both significant profits and large losses. Therefore, before starting work with derivatives, it is important to carefully study their features and possible risks to use these tools as effectively as possible (this and much more you can find in our service — Arbitrage Scanner in the training section).