Crypto Trading 101: Derivatives Trading

INTRODUCTION 

Derivatives let you trade around a token’s price action without owning it. They’re typically used by advanced traders for many reasons - to short sell, use leverage, avoid the complexity of custodying crypto assets, hedge positions, trade in higher liquidity environments, make money from funding rates, bet on future price movements & more. Crypto derivatives see some of the highest daily trading volumes across all crypto products. 

There are certain differences between traditional financial (TradFi) derivatives & those in crypto. In this guide, we’ll learn about how they work, why traders like using them - and understand the different types of derivatives that exist.

SUMMARY

• Derivatives are financial instruments that ‘derive’ their price from the price of the underlying asset.
• There are 4 main types of derivatives in TradFi: Futures, Options, Forwards, and Swaps.
• Derivatives exist for crypto assets as well, but certain types of derivatives, like perpetual futures, are more popular in crypto than in TradFi - and certain types of TradFi derivatives are not often used in crypto very often at all.
• There are a number of unique scenarios and reasons to trade derivatives rather than a token directly.
• Crypto derivatives can be traded off-chain, such as through a brokerage or centralized exchange, or on-chain, such as through an on-chain perpetual futures exchange or on-chain options protocol.

WHAT ARE DERIVATIVES?

Derivatives are financial assets that ‘derive’ their value from another asset. For instance - oil futures, a widely traded derivative, are contracts for the purchase of crude oil at some date in the future. Their value is based on the value of the underlying asset, oil, even though oil futures traders practically never take possession of this underlying asset..

Derivatives use different mechanisms to determine their price relative to the underlying asset. Futures and options are two of the most common types of derivatives.. In traditional markets, two other types of derivatives contracts are also commonly used: Forwards and Swaps.

WHAT ARE CRYPTO DERIVATIVES?

Crypto derivatives are basically the same as their traditional counterparts. Similar types of derivative contract exist for BTC and ETH as for commodities or equities in TradFi. However, due to the nature of crypto-assets, certain types of derivatives are more popular in crypto than others. And certain types of TradFi derivatives are not common in crypto Such as interest-rate swaps and forward contracts.

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Leverage trading is another major type of derivatives trading, in which traders borrow assets to trade with, requiring only a portion of their trade’s size to be put down as collateral. This collateral, or ‘margin’ allows the trader to keep the position open as long as they do not take a larger loss than their margin would allow them to keep open - letting them trade with more money than they have. Leverage is widely used by traders to increase their upside, but also risks higher losses from unsuccessful trades.

For example, 100x leverage means that the trader is able to take position sizes 100 times the amount of collateral they put down. The downside is that such high leverage means that even a slight move against your trade would cause a liquidation - a loss of the trader’s full margin. Learn more through Arkham’s explainer on leverage.

WHAT TYPES OF DERIVATIVES EXIST?

In crypto, there are 3 main types of derivatives: expiring futures, perpetual futures, and options.

Expiring Futures: These are agreements to buy or sell an item in the future at a predefined price. This may be because a trader anticipates a change in price or wishes to take delivery of an item in the future with pre-defined costs. For instance, Bitcoin miners will produce a predefined amount of Bitcoin and consume a predictable amount of energy. This means that they may want to buy short contracts - and agree to sell their produced BTC at a price that they can guarantee to be profitable.

The most popular kind of expiring futures are quarterly futures - these are available on exchanges such as the CME andBinance. Due to the expiration date, there is an incentive for arbitrageurs to buy these contracts when they trade below spot price, and to sell them when they trade above. This is how the price of quarterly futures contracts is kept aligned with the price of the underlying asset.

Perpetual Futures These are futures contracts without an expiry date. They’re among the most popular types of futures contracts in crypto and are widely used across by both CEX & DEX traders. These contracts anchor themselves to spot price through a method called “funding”. Funding payments are periodic payments made every hour from one side to another - depending on whether the contract trades above or below the price of the underlying asset, and the distance between the price of this instrument and the spot asset. 

A positive funding rate means that traders taking long positions are willing to pay those who are short for keeping their position open. Negative funding rates imply the opposite - that short positions are willing to pay long positions to keep their trade opent. These payments are typically paid every 8 hours and are used to keep the perpetual future’s price as close as possible to the spot price.

Options: By purchasing a futures contract, the trader has some exposure to the underlying asset. However an options contract is different in the sense that it allows a trader to purchase optional exposure to an asset - meaning, they have the right to buy an asset like Bitcoin at a future date, at a predetermined price, or let it expire if the price they’ve agreed upon is higher than the actual price of Bitcoin on the day the option expires. You can think of this as the trader purchasing a futures contract - but only needing to close it out if the contract pays out positively.

Options can be call options (options to buy) or put options (options to sell). They have an expiry date and a strike price, the price at which the option holder can buy/sell before the expiry date Options buyers must typically pay a premium in order to purchase them, which we’ll illustrate below:

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• Say the price of ETH is $2,000.
• A trader anticipating a swift upward movement within the next 3 months purchases call options at a strike price of $3,000, with an expiry date 3 months in the future. This means that at any point in the next 3 months they can buy ETH for $3,000. This option is worthless now, but the trader is betting that ETH will go above $3,000 in the next 3 months, making it valuable.
• The trader will have to pay a small premium to purchase these options (e.g. $100 per contract of 1 Ethereum).
• Say the trader buys $1000 of these Ethereum call options- providing 10 ETH of positive exposure above $3,000.
• Say the price of ETH moves to $3,500 2 months after the trader buys these options. He can then exercise the options for a profit of $500 per ETH - a total payout of $5000.
• Compared to buying $1000 of the underlying Ether, he would have only been able to realize a profit of $750 from that price movement. Hence options can provide higher upside for the same price move if traded successfully.

Options can be purchased as American or European style options. American-style options can be exercised at any point up to their expiry date, while European-style options can only be exercised on the expiry date. Crypto options can be purchased on many different centralized and decentralized platforms, such as Deribit, Opyn or Lyra.

DERIVATIVES IN TRADITIONAL FINANCE

In TradFi, there are 4 main types of derivatives.

Quarterly futures and options exist as they do in crypto. However, perpetual futures are not as commonly found in TradFi as they are in crypto, and are not commonly traded on the largest exchanges.

Two types of contracts found more often in TradFi than crypto are forwards and swaps.

Forwards are non-standard futures contracts arranged between two specific parties and involve a custom date, size, and occasionally product. Since these are custom contracts, they are often arranged directly between the two parties and are not very liquid. 

Swaps are contracts that exchange certain cash flows. Usually these are used by parties to exchange fixed interest for variable interest (or vice versa) - to either lock-in or speculate on future interest rates. Certain types of swaps can also provide hedging or insurance to the buyers, such as a CDS - credit default swap. In this case, the buying party is essentially buying insurance on a loan, and will be made whole if the originator of that loan defaults on their debt.

RISKS & BENEFITS OF TRADING DERIVATIVES

Leverage: With derivatives traders can effectively trade with more money they have. It lets them:

1. Free up capital for other trades
2. Keep less capital on an exchange - meaning they are less exposed to the counterparty risk of a loss of funds if an exchange fails
3. Trade with larger position sizes, amplifying their gains - but also their potential losses.

Overuse of leverage however, can cause traders to swiftly wear down their bankroll if they do not practice appropriate risk management. Excessive losses from poor risk management can be a key factor in why futures trading causes a large number of retail traders to lose money.

Short Selling: Derivatives allow traders to bet on the price of an asset going down, which can’t really be done by trading an asset directly. This allows pessimistic traders to more strongly express their opinions on a market.

However it is worth noting that the upside of shorting is capped - an asset can (at maximum) go to 0. However the upside of an asset is in theory unlimited. 

Avoid Custodying Crypto: Derivatives allow one to avoid the costs and risks associated with holding an asset directly. In crypto these negatives include transaction fees, the cost of self-custody, and the risk of custodied funds being lost or stolen.

Liquidity: Due to the other benefits of trading derivatives, derivatives markets tend to have greater liquidity than spot markets, which means less slippage, greater efficiency, and a lower risk of manipulation.

Complex Trading Strategies: Derivatives allow users to conduct more complex trading strategies, such as betting on specific price changes, creating optionality, and hedging spot exposure . These strategies aren’t possible with the mechanism of buying & selling an asset directly. 

However, one might argue that due to their complexity derivatives are unsuitable for ordinary traders. For this stated reason a number of governments have taken steps to either impede or entirely prohibit the trading of derivatives by retail traders - as the UK’s Financial Conduct Authority (FCA) in January 2020.

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WHY DO CRYPTO DERIVATIVES EXIST?

Alongside the aforementioned advantages for traders, crypto derivatives help maintain liquid markets and provide traders with efficient methods of speculation. They allow exchanges to provide clearing and settlement services to a pool of trading capital that is far larger than the capital they actively maintain on their books, because a large amount of the speculative interest can be matched with opposing orders from competing traders or market makers.

According to efficient markets theory, as more trading interest is expressed on a certain product or instrument, the more accurately its price is expressed - this means that allowing capital-efficient speculation is a good thing for not only the exchanges and traders, but also markets as a whole - essentially, trading actual prices of assets unimpeded by the quirks of the exchanges or the functioning of markets.

WHAT IS THE MOST TRADED CRYPTO DERIVATIVE?

CME Bitcoin Futures have recently overtaken Binance’s BTC-USDT product as the most traded crypto derivative with. This is only the second time this has occurred in the past 2 years - ordinarily Binance’s BTC-USDT Perpetual is the most traded crypto derivative.

BTC-USDT PERPETUAL FUTURES EXPLANATION

BTC-USDT Perpetual Futures is one of the most traded futures products. This is a perpetual future that tracks the spot price of BTC against Tether USDT, and allows traders to speculate on price movements without owning BTC. It’s an extremely common pair across a number of exchanges.

Exchanges use a number of mechanisms to calculate the current price of BTC expressed on their BTC-USDT perpetual product. One is the price index of BTC - this is the weighted average of BTC’s spot asset price across a number of major exchanges. This is to ensure that traders are not adversely affected by price manipulation on a single exchange or order-spoofing. This helps them most accurately reflect the price of the underlying asset BTC.

The mark price is the current price of the perpetual futures instrument BTC-USDT and may slightly differ from the price index by some small amount. This is because traders taking large positions may push the price of BTC-USDT Perpetual Futures higher or lower than that of the price index.

Traders are incentivised to keep the mark price roughly similar to the price index through funding payments. This is where traders on one side pay the difference in mark price and price index to the other side - if the BTC-USDT futures price (mark price) is higher than the price index, traders holding long positions will need to pay the % difference to short positions - and vice versa. This encourages traders to engage in arbitrage when futures prices move out of position with the underlying spot price.

Often, the direction of futures funding will indicate the prominent direction of speculative trading on an asset’s price.

ON-CHAIN VS OFF-CHAIN DERIVATIVES

Most of the products discussed so far in this article are hosted by centralized exchanges or are accessed through traditional brokerages - however, on-chain equivalents also exist for many popular derivatives products in crypto. Most notably, on-chain perpetual exchanges such as DyDx, GMX, and Kwenta provide on-chain traders with access to perpetual futures, while on-chain options protocols such as Opyn, Hegic or Dopex provide traders with access to on-chain options trading. Due to the frequency of transactions that need to be made by derivatives traders, on-chain derivatives protocols are frequently hosted on L2’s such as Arbitrum and Optimism, or alt-L1’s like Solana, in order to facilitate cheaper and faster transaction finality for their users.

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CONCLUSION

Derivatives are financial products that facilitate increased levels of speculation, liquidity and price discovery in crypto markets. These are powerful tools in the arsenal of individual traders, providing them with the ability to hedge, speculate, or construct pair trades to express more specific beliefs about the markets. Many different types of derivatives exist, and their levels of popularity vary within the crypto market, just as they do across TradFi markets. However, due to their complexity, derivatives come with an added level of risk and difficulty compared to spot markets. Amateur or novice traders are likely to lose money trading derivatives due to their lack of experience and the presence of much more sophisticated players in the market.

Just as with other financial products, traders must practice careful risk management and consider position sizing before entering into any derivatives trade to mitigate downside risk and ensure that they are accurately expressing their views on the market.