Many cryptocurrency traders never venture far beyond buying and selling the asset itself, no matter which currency we’re talking about, maybe holding it a little bit to see if they can sell it for a profit. However, if you have traded at all, or even just read a few articles about it, you have probably heard about derivative trading. Admittedly, for many, derivatives are a little too advanced—which doesn’t mean they have to be hard to understand.
A derivative is a contract between two parties which derives its price from its underlying asset, which can be stocks, bonds, market indices, (crypto)currencies, and various other assets. The origin of derivatives can be traced back to ancient Greece, where the philosopher Tales (according to Aristotle) entered a contract transaction of olives and made a profit in the process. Historically, they were used to account for differences between currencies when doing international trade, but nowadays they have innumerable users far exceeding (but still including) this one.
Types of Derivatives
The four most common forms of derivatives are futures, perpetuals, swaps, and options. Before delving into the details, you also need to know the difference between exchange trading and over-the-counter trading.
An exchange is a place where assets are traded. In traditional finance, they act as the counterparty to all trades, ie. you’re not buying assets from the seller, but the seller sells it to the exchange, and you buy it from the exchange. This also ensures that the quoted price is the same to all parties in order to ensure a level playing field. However, there is also the usual risk associated with centralization, which is why the cryptocurrency industry has introduced the concept of a decentralized exchange, which is in most cases just a different name for over-the-counter (OTC) trading.
Over-the-counter (OTC) trading is a decentralized market where participants can trade directly with each other, without a central authority to go through. They tend to have lower transaction costs and fewer security concerns than centralized exchanges.
Now we can dig deeper into specific types of derivatives.
- Futures contracts. Often simply called futures, they are an agreement between two parties for the purchase of an asset at a certain price on a certain future date, and they’re traded on an exchange. Once that date comes (ie. the contract expires), the parties are obliged to uphold the agreement, meaning they can’t just choose not to buy/sell in case it’s not so profitable anymore. For example, one party might need more wheat in three months’ time, but they’re concerned that the weather will affect the crops negatively and the price will rise due to a rise in demand. When they buy a futures contract for a certain amount of wheat at an agreed upon price, the selling party is obligated to sell it to them at the same price after those three months are over, regardless of whether or not the price actually rose in the meantime. The buyer is also profiting in a way by not having to purchase wheat at the current price, while the seller will get their payment even if the price falls so they may also profit. Thus, futures are most often used as a way to hedge risks.
- Forwards. Forwards are almost exactly the same as futures, except they only trade over-the-counter (OTC), never through an exchange. This is slightly riskier, since one party could become unable to uphold their part of the deal by becoming insolvent, for example, so the other party has no recourse.
- Swaps. These are derivatives that do not trade on exchanges, only OTC, and retail investors typically do not engage in them. In short, a swap is a contract in which two parties exchange (or swap) the cash flows or liabilities from two different financial instruments. Although the instrument can be anything, it’s usually loans or bonds, and the most common type is the interest rate swap in which one leg, or part of the swap, is variable and the other is fixed. This is mostly done to hedge against an interest rate risk or to speculate. There are several other types aside from interest rates with different criteria, but they are of very little interest to retail traders in general.
- Options. Options are also extremely similar to futures. They’re an agreement to buy an asset at a certain price on an upcoming date. However, unlike contracts, they pose the option to buy or sell, and not an obligation. They are also very often used to speculate on the price or hedge risks.
A Closer Look Into Options
Since Light.CX offers options trading at this time, let’s take a closer look at this derivative through an example. If you own an asset that is worth $50 today but its price may drop, you can buy a put option which gives you the right to sell the asset for $50 (the strike price) at a certain future date. At that date, if the price of the asset falls to $45, you’re effectively profiting by selling it at your strike price.
Alternatively, let’s say you don’t own something but you’re convinced its current price will be higher at a certain point in the future. By buying a call option, you’re getting the right to buy the asset at the current price (the premium) at a specified date in the future. If it rises, you’re getting the asset for a lower price, also profiting.
In either case, there is no inherent obligation to buy the asset after the contract expiration date, but the seller is obligated to fulfill their side of the contract if the buyer still wants to buy. In the first example however, if the price at the contract’s expiration is above the strike price, the put is effectively worthless, but the seller gets to keep the premium. A similar thing happens with the call: if the price is below the strike price, the option is worthless, but the call seller keeps the premium.