The term derivative refers to a type of financial contract whose value depends on an underlying asset, asset class or benchmark. A derivative is established between two or more parties who may trade on a centralized exchange (CEX) or over-the-counter (OTC).
These contracts can be used to trade any number of assets and carry their own risks. Prices of derivative are based on the fluctuations of the underlying asset. These financial securities are commonly used to access certain markets and can be traded to hedge risk. Derivatives can be used either to mitigate risk (hedging) or to expose oneself to risk with the expectation of higher rewards (speculation).
Types of derivatives:
- Futures: an agreement between two parties to buy or sell an underlying asset at a specified price on a specified date in the future. This price must be paid in the future, even if the price of the underlying asset is different from the agreement. Futures are traded on exchanges, making the contracts standardized.
- Options: these are another type of derivative contract, allowing a trader to buy or sell a specific asset at a set price at a future date. However, unlike futures, Options allow the buyer not to buy the asset if they choose not to do so
- Swaps: derivative contracts used between two parties to exchange one type of cash flow for another. The most popular types of swaps relate to interest rates, commodities and currencies. They are OTC contracts.
- Perpetual contracts: these are also called Perpetual futures contracts or Perpetual swaps. The main difference between Perpetual contracts and futures / swaps is that a Perpetual contract has no expiration date. Positions can be held for as long as the trader wants, provided they pay holding fees. These fees are called the funding rate. The account must also contain a minimum amount or margin.
- Low fees
- Own risk management
- They improve market efficiency
- High risk
- Price speculation
Crypto derivatives are essential for the world of crypto because their functions extend far beyond the investment portfolio of individual traders. Derivatives are part of any mature financial system and therefore play a key role in the development of the cryptocurrency industry as a recognized asset class.
Trading derivatives is much riskier than simply owning the underlying asset. Derivatives are always more volatile than the underlying asset. The crypto world is a very volatile class of asset in itself, so derivatives are even more volatile. You can also trade derivatives with leverage, which increases the risk of liquidating your account. Therefore, I would not recommend new or intermediate investors to trade derivatives. If you want to try it anyway, it’s safer without leverage.