Swapping digital assets isn't the only way to trade cryptocurrencies, nor is it the most popular way to speculate on virtual coins. Recent trading activity suggests financial instruments called derivatives are more commonly used by crypto traders than the cryptocurrencies they represent.
In fact, crypto derivatives account for almost 75% of the total crypto trading activity, averaging between $1 trillion and $3 trillion in quarterly trading volumes. Some researchers estimate trading activity for crypto derivatives is often five times greater than for literal cryptocurrencies.
There's no denying the dominance of derivatives in the crypto ecosystem, but why have they become such a hot option? Let’s explore how crypto derivatives work, what they offer to traders, and how to fit them into a digital asset portfolio.
What are crypto derivatives?
Crypto derivatives are tradable contracts that derive value in relation to digital assets’ market prices. Traders who buy derivatives don't own cryptocurrencies in a digital wallet; instead, they hold paper financial products that give them a way to speculate on the prices of coins like Bitcoin (BTC) or Ethereum (ETH).
Each crypto derivative comes with rules buyers and sellers agree to when entering a contract, including an expiry date, a digital asset’s agreed-upon market price, and how much cryptocurrency a contract holder can buy or sell. Some exchanges settle derivatives with cryptocurrencies, but many platforms, like dYdX, let eligible traders use stablecoins or fiat currencies when opening and closing derivative positions.
Popular crypto derivatives
There are three significant categories of cryptocurrency derivatives, each with a distinct set of restrictions and value propositions. Traders use the differences between these crypto derivatives to craft their ideal strategies depending on their goals and current market dynamics.
1. Crypto options
With crypto options trading, the contract holder can either buy (call option) or sell (put option) a fixed amount of an underlying cryptocurrency at a set price (aka strike price) by an expiration date. The critical trait separating crypto options trading from other derivatives is that buyers aren't obligated to exercise their contract. Only option sellers must fulfill their end of the agreement if a contract holder decides to buy or sell the underlying cryptocurrency.
2. Crypto futures contracts
Crypto futures have many of the same features as options—including expiry dates, strike prices, and a prearranged coin quantity—but buyers can’t choose whether to exercise their derivative, they have to.
When traders enter a futures agreement, they must transfer the agreed-upon cryptocurrency (or a cash equivalent) at expiration. Long futures contracts mean a crypto trader profits if the virtual currency increases in value, while short futures gain value as a cryptocurrency's market price decreases.
3. Crypto perpetual contracts
Also called perpetuals swaps or perps, crypto perpetuals are a new breed of futures contracts, popularized by dYdX, that don't have expiry dates. Instead of settling contracts with counterparties in preset time intervals, these contracts use a dynamic fee-and-rebate model to incentivize or disincentivize market participants on different trade sides. When there are more longs than shorts in a perpetual, the long traders pay fees to shorts to balance out demand, and vice versa when shorts have the upper hand.
Pros and cons of crypto derivatives
Crypto derivatives give traders more control over their market strategies but expose them to risks not found in the spot market. Anyone new to derivatives must weigh the potential benefits of these contracts against common issues to avoid surprises when opening their first position.
Crypto derivatives pros
Superior capital efficiency: With derivatives, traders don't need as much capital to take sizable positions on digital assets. Many crypto derivatives exchanges make it easy to borrow additional funds, instantly increasing a portfolio's size and amplifying gains if traders have a winning position.
Easy betting against cryptocurrencies: Contracts like put options and short futures make it simple for traders to take positions when they expect major price declines (aka bear markets). With these tools, traders can profit during down markets and mitigate short-term losses (aka hedge) in their long-term crypto portfolios.
Secure self-custody: Because derivatives are paper assets, crypto traders don't have to deal with the complexities of opening a self-custodial crypto wallet and the security risks of storing their virtual coins. Traders who aren't ready to secure virtual currencies still enjoy price exposure to digital assets through crypto derivatives.
Complex trading strategies: As traders learn about derivatives, designing elaborate trade setups with intricate risk and reward profiles is possible. By combining options, futures, and perpetuals, experienced traders can place positions in any market condition.
Crypto derivatives cons
High risk exposure due to margin trading: Margin trading is a double-edged sword for derivatives traders. While taking out a leverage position boosts gains in a favorable position, it magnifies a trader's losses. In worst-case scenarios, taking out leverage positions on a bad trade forces traders to sell their entire portfolio (aka liquidation). If margin traders don't know basic risk management strategies, such as using sell-stop orders or analyzing price charts, they're vulnerable to major risks.
No tangible assets: Derivatives traders can't take advantage of the unique value proposition of holding literal cryptocurrencies in a private wallet. For example, people trading derivatives can't use passive income opportunities like staking or interact with decentralized finance (DeFi) protocols for peer-to-peer (P2P) trading or borrowing.
Counterparty risks: Since two parties are involved in each derivative contract, buyers face default risk if sellers fail to meet their obligations. Also, derivatives traders depend on their trading platform’s reliability and security, meaning losing money is possible if their exchange has a technical issue or mismanages user funds.
Higher learning curve: Trading derivatives isn't as intuitive for new traders as buying cryptocurrencies directly on a spot exchange, and many platforms offering crypto derivatives have a user interface tailored for advanced traders. Beginner crypto traders may feel overwhelmed by the concepts and complex charting tools when exploring the brave new world of derivatives.
How to get started on a crypto derivatives exchange
Traders looking to add crypto derivatives to their strategy should follow the below steps to get started:
Find an exchange with the preferred financial products.
Search through crypto derivatives exchanges by visiting a crypto price aggregator site like CoinMarketCap or CoinGecko and click the Exchanges tab. Both websites have filters for derivatives with data such as each platform's daily trading volumes, available products, and safety profiles.
Carefully research the features and reputation of each crypto derivatives exchange before deciding which one is the perfect fit. If traders want to create an account on a centralized crypto exchange (CEX), they'll need to submit personal know-your-customer (KYC) details like their name, email address, and phone number to verify their identity. For decentralized exchanges (DEXs), conversely, eligible traders must link a compatible self-custodial crypto wallet to make P2P derivatives swaps.
Once you've selected an exchange that aligns with your needs, conduct your own research on the tokens and understand the price movements before opening a position. This involves analyzing market trends, understanding the factors that influence the value of derivatives, and staying informed about the latest news and developments in the cryptocurrency world. This step is crucial in making informed trading decisions and managing risks effectively.
Eligible traders can trade crypto perpetuals on dYdX
dYdX is a pioneer in crypto perpetual swaps. Since the launch in 2017, eligible traders have enjoyed access to deep market liquidity for the hottest perpetual contracts using dYdX's user-friendly and secure decentralized protocol. For more details on dYdX's latest features and updates—including our groundbreaking dYdX Chain—check out dYdX's official blog. Also, visit dYdX Academy for more educational articles on cryptocurrencies, trading strategies, and Web3 technologies, and eligible traders can start trading on dYdX today.
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