The derivatives market has stood out as one of the most lucrative trading ecosystems given that participants can bet on the future prices of underlying products. It is now finding a way into the burgeoning crypto market following recent price surges; Bitcoin, which leads the pack, broke its previous all-time high of $20,000 and has since doubled the value to test $42,000 at the beginning of January.
That withstanding, the evolution of digital assets technology is gradually coming of age from both a fundamental perspective and technical outlook of the market. The introduction of crypto derivatives is an example of this growth, especially for market makers who mostly rely on diverse products to fuel their trading activity. Unsurprisingly, an increased product range seems to have attracted more capital with the crypto market cap hitting $1 trillion.
The Value Proposition of Derivative Markets in Crypto
While derivatives have existed in traditional markets for quite some time, most people find it difficult to interact with this asset class despite its value proposition in hedging strategies. Well, the concept basically involves acquiring a market product ‘derivative’, whose value is derived from an underlying asset. Such markets exist for financial products as well as commodities ranging from precious metals to farm produce.
The crypto market is the latest space to integrate derivatives for various products that define its growing ecosystem. As expected, derivatives have gained traction amongst the savvy crypto community; in fact, they are now being used to gauge market sentiment from a macro-perspective. Stakeholders believe that this emerging trend could be pivotal in predicting crypto prices as the market structure evolves.
Crypto Derivative Products
Crypto borrows its current derivative products from the traditional finance setup, where these tools have grown and now trade in trillions of U.S dollars. These are some of the most liquid crypto derivative products as of press date;
Futures – Derivatives
A cryptocurrency future is a contract to buy or sell an underlying digital asset at a future date for a fixed price, regardless of the asset’s prevailing market price on the settlement day. These contracts oblige the holder to act on them upon expiry which means that they have to execute the buy or sell at maturity.
Ideally, one could predict that a particular digital asset’s price will have fallen at a future date and hence initiate a contract to sell an underlying asset at a higher ‘predicted’ rate. Upon maturity, their position is either in or out of the money, depending on the asset’s price at execution.
They are pretty similar to futures with the only difference being that the former can be customized to suit the trading parties. Forwards trading takes place over the counter (OTC) which means that market makers have to engage dealers for the contracts to be initiated.
Options – Derivatives
Crypto options are another upcoming derivative class and offer opportunities for portfolio diversification strategies as well as risk management. Options give the holders a right, but not obligation to act on the contract upon maturity. Unlike Futures, this asset class allows one the flexibility of speculating on an asset without fully committing to buying or selling the asset at expiry. Instead, they can choose to forego the option contract and incur its premium cost as the only loss.
These are basically advanced clones of crypto Futures that allow market makers to take perpetual derivative trading positions. Perpetual crypto contracts do not have expiry dates, giving the flexibility of holding a position till profit realization. However, traders are required to top up their positions regularly so as to maintain the contract.