The cryptocurrency market has grown over the last decade into an ecosystem with well over 3,000 cryptocurrencies with blockchain technology as the common feature. The early days of the industry were mainly pioneered by retail investors who speculated on the price of the assets. However, institutional investors are coming to the party, and this is evidenced by new financial products such as Bitcoin Derivatives.
What is a derivative?
A derivative is a financial contract that derives its value based on the future performance of an underlying asset. Going into detail, a derivative is an agreement between parties to buy or sell a specified asset at a set time in the future.
Derivatives do not have a value on their own. They derive their value from the expected future price movement of the underlying asset.
Derivatives have been discussed a lot in the crypto industry especially when it comes to bitcoin futures contracts. The derivatives market is one of the oldest markets in the financial world and its history goes back to medieval times.
Derivatives have evolved over the years and are rated highly among popular financial tools. The most common forms of derivatives include futures, swaps and options.
Why would a trader use derivatives?
The first important thing to note is that derivatives are advanced financial instruments that are mainly used by sophisticated or technical traders. Derivatives are mainly used for hedging, speculation, and protection from price volatility.
Traders turn to derivatives to protect their trading portfolio in an effort to minimize potential future losses. Institutions and sophisticated traders use derivatives as a risk management technique. Hedging can also be seen as an insurance policy for your portfolio.
As an example, a wheat farmer will draw up a futures contract with a miller to sell a specified amount of his produce for a specific amount of money in the future. The two parties have minimised the potential risks in the future. The wheat farmer is insured against the uncertainty of the wheat price in the future while the miller is insuring himself against the unavailability of wheat in the future.
However, both parties have also acquired additional risk which could negatively impact them in the future.
By specifying a set price for the wheat, the farmer has closed out the possibility of making extra income if the price of wheat increases in value in the future. This works in favor of the miller who may buy the wheat at a lower price in the future.
The risk taken by the miller is also similar. He will be forced to buy the wheat at the set price, but it is also possible that the price of wheat may decrease in the future. The miller will be paying a premium in this instance and the farmer makes the most from it.
In some cases, derivatives can be used to speculate rather than hedge. Traders will enter into a derivatives market to speculate on an asset, hoping that the party seeking insurance will be proved wrong in the future.
Speculators bet on buying an asset in the future at a lower price according to the conditions specified in the contract when the price of the asset goes up, or sell the asset at a higher price in the future when its price goes down.
In our wheat and miller example, if a miller foresees unfavorable conditions such as bad weather, he may be sure that the price of wheat will rise significantly in the future. By entering into a derivative contract with a farmer, he is guaranteed that he will buy the wheat at a lower price.
The farmer may predict that wheat’s price will decrease in the future and will use a derivatives contract to ensure that he sells his produce at a higher price. In both instances, each party is betting against the insurance policy that the other party is seeking.
Protection against volatility
One of the main reasons for the use of derivatives is insurance against price volatility. As an example, you can enter into an agreement with an airline to pay a fixed amount for an airline ticket now to avoid a price increase closer to the date you need to fly.
This is similar to a derivatives contract where the amount of money you will be paying now in exchange for specified services is laid out in the contract. This way, you have locked your airline ticket price and you won’t lose sleep if oil prices increase which causes airline prices to increase as well. You are protected from price fluctuations but you will lose out if the price of the airline ticket drops.
Common forms of derivatives
This section explains the previously highlighted forms of derivatives: futures, swaps, and options.
A futures contract, mostly known as futures, is a contract between two parties for the purchase and delivery of a specified asset at a specified price set for a future price. The parties involved in the futures contract are obliged to fulfill their role.
For example, an airline company buys a futures contract to buy jet fuel at a price of $70 per barrel from another company and needs to have it delivered in a month. The airline is guaranteed that the supplier will deliver the fuel when the contract expires. It is possible that the price of fuel may rise to $80 per barrel, in this instance, the airline company can sell the contract before it expires and makes a profit from the transaction.
This is an example of a contract where both parties may have been hedging against risk and it is also possible that they were both speculating against the direction of oil price movements in the future.
Futures contracts are traded on exchanges.
A swap is a contract between two parties which involves a series of cash flow exchanges on or before a predetermined future date based on the value of interest rates, bonds, stocks, commodities exchange.
A common swap is a foreign currency swap (FX swap). A foreign currency swap is effectively loaning one currency to a certain party in exchange for borrowing another currency. Two parties may want to agree to an FX swap in order to get better loan rates in a foreign currency, to do business in a certain country and use their national currency, or to make a trade for one currency against another.
As an example, Company A wants a loan in Australia and company B wants a loan in France. Company A is from France and company B is from Australia. In order to get better loan terms, they exchange loan amounts to get the loan in the currency they desire.
Most crypto derivative exchanges use futures or options. However, Overbit uses swaps to easily allow cross-market trading using Bitcoin as the underlying asset. This means users are able to buy USD, JPY, EUR, or different metals with their Bitcoin with BTC/USD emerging as the most popular trading pair amongst traders. Unlike futures, Overbit contracts are perpetual, meaning they never expire. Users are able to use leverage which reduces the cost of capital needed to trade a larger amount long or short.
An options contract is more like a futures agreement in the sense that two parties enter into a contract to buy or sell a specified asset at a future date for a set price. The major difference between the two is that the buyer is not obliged to keep their end of the bargain.
An options contract is based on opportunity while a futures agreement is based on obligation.
How are derivatives used in Bitcoin trading?
For those that have been in the cryptocurrency industry long enough, they know how the prices of digital assets fluctuate. In December 2017, bitcoin reached its all-time high of nearly $20,000 but surrendered most of its gains within just a few weeks. The price of the leading digital asset continued to drop throughout 2018 and reached the bottom of $3,200 by the end of the year.
Things took a turn for the better in 2019 and the prices have increased steadily since April.
The Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) launched bitcoin futures trading at the height of the bull market in 2017. This was a major milestone for the industry as the futures contracts allowed traders to hedge against price volatility.
It was also a milestone step because it offered some bit of legitimacy to an industry largely seen as a financial experiment at the time.
As a bitcoin trader, you are likely going to benefit from trading crypto derivatives such as bitcoin futures. One of the best ways to make money in the cryptocurrency industry is speculation, buying low and selling high. Unfortunately, this method is only relevant in a bull market.
In a bear trend, Bitcoin traders can turn to a strategy known as shorting, which is a way of profiting from a bearish cryptocurrency market.
Cryptocurrency traders usually borrow the underlying cryptocurrency asset – bitcoin or others – from a third party such as an exchange or broker and sell it to the market at a certain price. When the price of the cryptocurrency goes down, the trader buys back the same amount of assets for a lower price and makes a profit from the price movement. The exchange makes money by earning a commission from the trade.
Where can I trade Bitcoin derivatives?
You can start trading Bitcoin derivatives straight on Overbit’s trading platform. The process is very simple:
- Sign up for an account
- Earn a free welcome bonus by verifying your mobile phone with a SMS code
- Trade Perpetual Swap Contracts
- Deposit Bitcoin if you want to amplify your trades
Overbit gives you the ability to trade Bitcoin against other cryptos, fiat currencies, and metals like Gold and Silver. Overbit is proud to offer zero trading fees and we reward loyal users through tier points that give you the ability to earn Bitcoin as you trade and refer others to the platform.
Are there any downsides to trading Bitcoin derivatives?
No Bitcoin and cryptocurrency trading strategy is exempt from risk due to price fluctuations.
Crypto derivatives traders normally face the risk of price volatility. The prices of cryptocurrencies can fall at rapid rates, and losses can get significantly larger when you are trading on margin. The best way to deal with this is to fully understand the features available on a trading platform and make sure that you have a solid strategy for executing your trades.
It is also important for bitcoin traders to keep their ears on the ground for news, large movements on the blockchain and regulatory announcements - as these factors tend to weigh heavily on volatile movements.
Just keep in mind that derivatives trading is a double-edged sword, it can amplify both your gains and your losses. Overbit showcases an easy to use interface with a simple to understand contracts, no price manipulation, and a liquidation process that protects your funds.
Overbit is giving away $1 million USD worth of Bitcoin in bonuses. Sign up and get a free bonus of $30 USD. No deposit required! Wait, there’s more! Users who deposit an amount equal or above 0.2 BTC will receive a $200 USD deposit balance (paid in BTC) immediately upon deposit.
Trading Derivatives carries a high level of risk to your capital and you should only trade with money you can afford to lose. Trading Derivatives may not be suitable for all traders, so please ensure that you fully understand the risks involved, and seek independent advice if necessary.
The content on Overbit's website, blog, social media or any other platform is not intended to target any specific country or territory and its residents. Please check the applicable regulations of your country or territory before accessing Overbit’s platform.