Derivatives have a long and fascinating history, which dates to ancient Mesopotamia, where farmers used forward contracts to secure prices for their crops well in advance. This practice spread to Ancient Greece and Rome, where similar contracts were employed for essential commodities such as olives, grain, and even oil. These early forms of derivatives laid the groundwork for modern financial instruments, enabling participants to hedge against price volatility and secure more predictable profits or costs.
In today’s article, we explore some of the most popular ways in which one can engage with the exciting world of cryptocurrencies. Whether through futures contracts, options, or perpetual swaps, traders have multiple ways to scope the markets for a potential profit, while managing the risks associated with each strategy. Let’s dive into the mechanics of each type of derivative, their benefits, and the risks involved, so you can gain a better understanding of how these instruments are shaping the crypto trading landscape.
Derivatives in Crypto Trading
With the rise of digital currencies, derivatives have evolved to meet the demands of the fast-paced cryptocurrency markets. Unlike traditional derivatives tied to physical goods or financial instruments like stocks and bonds, crypto derivatives provide traders with the ability to speculate on price movements of cryptocurrencies without owning the underlying assets. As a result, crypto derivatives have become complex financial tools, used in both high-return and high-risk strategies.
Traders and investors alike employ them for hedging, arbitrage, and speculative purposes, given their potential for magnifying both gains and losses. These instruments have opened up a world of opportunity but require a keen understanding of market dynamics, leverage, and risk management. Let’s now recap the most popular crypto derivative instruments, each having its own distinct key features for traders looking to navigate the fast-paced world of cryptocurrencies.
Crypto Futures Contracts
Cryptocurrency futures are legal agreements that bind traders to buy an asset at a predetermined price on at a future date. These contracts have a specific number of units, marginal requirements and settlement methods for them to be traded with brokers or exchanges worldwide.
Key features:
- Expiration Date: The contract specifies the exact date when the asset will be delivered or settled.
- Leverage: Futures allow traders to control large positions with a relatively small amount of capital.
- Hedging: Futures can be used by hedgers to protect against price fluctuations, or profit from anticipated price movements.
Crypto Options Contracts
A crypto options contract is a financial derivative that gives the buyer the right, but not the obligation, to buy or sell an underlying asset (such as a stock, commodity, or currency) at a specified price, on or before a certain date. Unlike futures contracts, options provide the flexibility to either execute the trade or let the contract expire.
Key Features
- Strike Price: The price at which the buyer can buy (call) or sell (put) the asset.
- Expiration Date: The last date the option can be exercised.
- Premium: The price paid by the buyer to acquire the option.
- Leverage: Like futures, options allow traders to control larger amounts of the asset with less capital.
Crypto Perpetual Swaps Contracts
Perpetual swap contracts are a type of derivative that allows traders to speculate on the price of an asset (such as cryptocurrencies, commodities, or other financial instruments) without having an expiration date, unlike traditional futures contracts, which makes them popular in cryptocurrency markets.
Key Features
- No Expiration Date: Unlike futures contracts, perpetual swaps do not have a fixed settlement or expiration date. This means traders can hold their positions indefinitely, if they meet the margin requirements.
- Funding Rate Mechanism: Since there is no expiration date, perpetual swaps use a mechanism called the funding rate to keep the contract’s price aligned with the spot (or market) price of the underlying asset.
- Leverage: Perpetual swaps typically allow for high leverage, meaning traders can control larger positions with relatively small amounts of capital. However, this also increases the risk of liquidation if the market moves against them.
- Continuous Settlement: Perpetual swaps are settled continuously, meaning profits and losses are reflected in real-time as the market moves, rather than at a specific future date.
Leverage and Crypto Derivatives
Leverage is a key feature in all three derivatives—futures, options, and perpetual swaps—allowing traders to control larger positions with relatively less capital. However, the way leverage works, and the risks involved differ with each derivative type, so let’s quickly dissect each use case, while looking at some practical examples.
1. Futures Contracts
- Leverage Use: Futures contracts inherently provide leverage because traders only need to deposit a margin (a small percentage of the total contract value) to open and maintain a position. The margin acts as collateral and can be adjusted through initial margin (to open the position) and maintenance margin (to keep the position open).
- Leverage Ratio: The leverage ratio can vary but is often significant. If a trader uses 10:1 leverage on a $10,000 futures contract, they only need $1,000 to open the position. A 1% move in the asset price could result in a 10% gain or loss on the trader’s capital.
2. Options Contracts
- Leverage Use: Options provide inherent leverage because the buyer pays a small premium to open a market position for a larger amount of the underlying asset.
- Leverage Ratio: Options can offer high leverage exceeding 100:1, resulting in small moves in the underlying asset’s price largely impacting the option’s value. Let’s say a trader buys a call option with a strike price of $100 for a $2 premium. If the asset’s price moves to $105, the option’s value increases significantly, potentially providing substantial profits with a minimal initial investment.
3. Perpetual Swaps
- Leverage Use: Perpetual swaps, particularly in cryptocurrency markets, allow for highly leveraged positions with no expiration date. Traders deposit a margin, also known as collateral, to control larger positions, much like futures contracts. Leverage is continuously maintained as long as the margin requirements are met.
- Leverage Ratio: In perpetual swaps, leverage can be very high, often reaching 100:1 or even higher. This allows traders to control a large amount of the underlying asset with a small amount of collateral. A trader with 100:1 leverage on a $10,000 position needs to deposit only $100 in margin. If the market moves 1% against them, they could lose their entire position and face liquidation.
Risk Management for Crypto Derivatives in Trading
Trading crypto derivatives with leverage can offer high returns, but the amplified risks can lead to equally large losses if not properly managed. Because leverage enables traders to control larger positions than their capital would typically allow, even small price fluctuations in the market can result in outsized gains—or devastating losses. To navigate this high-risk environment, traders use a range of risk management techniques designed to protect their capital, minimize exposure to market volatility, and reduce the chances of their positions being forcedly liquidated. Here are some common and effective risk management strategies used in leveraged crypto trading:
1. Leverage Control
- What it is: Adjusting the leverage you use depending on your risk tolerance and market conditions.
- Why it matters: High leverage can amplify profits but also magnifies losses. In volatile markets like crypto, it is easy to get liquidated if the market moves against you even slightly.
- Best Practice: Beginners should use low leverage (e.g., 2x-5x) to minimize risk exposure. Experienced traders may increase leverage but should be aware of the heightened risk. Many platforms also allow you to adjust leverage during a trade, so consider scaling down leverage if volatility increases.
2. Diversification
- What it is: Diversification involves spreading your capital across multiple assets or markets to reduce overall risk.
- Why it matters: Crypto markets are highly correlated, but diversifying across different cryptocurrencies or other asset classes can help mitigate risks associated with price swings in any single asset.
- Best Practice: Don’t put all your capital into one leveraged trade. Spread your capital across various positions or assets to avoid large losses from a single market downturn.
3. Using the Funding Rate to Your Advantage (For Perpetual Swaps)
- What it is: Funding rates are periodic payments between long and short traders to keep the perpetual swap price aligned with the spot price. Depending on the market, you either pay or receive the funding fee.
- Why it matters: Constantly paying the funding rate can eat into profits over time. Traders holding long-term positions should monitor the funding rate to avoid paying high fees that could erode their capital.
- Best Practice: When funding rates are high, avoid over-leveraging, as the fees will add to your costs. Conversely, you can position yourself to earn funding by being on the opposite side of an overcrowded market, like shorting a crypto asset when the majority of traders are long.
4. Monitoring Liquidation Price
- What it is: The liquidation price is the price level at which the broker automatically closes a leveraged position to prevent further losses, ensuring you don’t lose more than your margin.
- Why it matters: If the market price reaches your liquidation price, your entire position is liquidated, resulting in a total loss of your margin.
- Best Practice: Always be aware of your liquidation price and ensure it’s far enough from current market levels. Use low leverage or increase your margin to push the liquidation price farther away from potential market fluctuations.
5. Avoiding Over-Trading
- What it is: Over-trading refers to executing too many trades or taking excessive risks without a clear strategy, often driven by emotions like fear or greed.
- Why it matters: In leveraged trading, frequent trades, especially without proper analysis, can lead to significant losses due to fees, market volatility, and emotional decision-making.
- Best Practice: Stick to a well-defined trading plan and only enter trades based on thorough analysis. Avoid impulsive trades, especially after a loss, as this can lead to revenge trading, which often results in more losses.
6. Hedging
- What it is: Hedging involves taking an opposing position in a correlated asset or derivative to offset potential losses.
- Why it matters: It helps reduce exposure to adverse price movements. For example, if you’re long on Bitcoin with leverage, you could open a smaller short position in a Bitcoin futures contract to reduce your risk in case the price drops.
- Best Practice: Hedging can help protect your capital, especially during volatile periods. Consider hedging strategies to minimize losses on large positions.
Hedging Strategies in Crypto Markets
As hedging offsets potential losses by taking opposing positions on correlated assets, it does not necessarily generate profits but protects a trader’s portfolio against adverse price movements, thereby reducing risk. This is especially critical in the crypto space, where dramatic price swings can occur rapidly due to factors like market sentiment, regulatory changes, or macroeconomic trends. Below are some of the most common hedging strategies employed by traders in the volatile world of crypto markets.
1. Using Futures Contracts
If you own a crypto asset and are concerned about a price drop, you can sell a futures contract to lock in the current price. If the price drops, the profit from the futures contract offsets the loss from holding the crypto asset. Hedging with futures contracts is best for locking in prices for future sales or mitigating downside risk in highly volatile markets.
2. Perpetual Swaps
Perpetual swaps are a type of futures contract that doesn’t have an expiration date, allowing for continuous hedging. If you’re holding a long position in a cryptocurrency, you can take a short position using perpetual swaps to hedge against potential price declines. These swaps have no settlement date, allowing you to maintain a hedge as long as necessary. Perpetual swaps contracts are great for long-term portfolios as they do not require contract rollovers.
3. Options Contracts
There are two ways in which you can hedge options contracts: with buying put options, which safeguards against price drops by giving you the right to sell an asset at the specified price, and selling call options, which generate premium income that can mitigate potential losses in a long position. Options contracts are best used for flexible hedging with limited risk, as the maximum loss that can occur is the premium paid for the derivative contract.
4. Delta-Neutral Strategies
A delta-neutral strategy involves creating a portfolio where the overall delta, which is the sensitivity to price changes in the underlying asset is zero, meaning the portfolio’s value is relatively unaffected by small price movements. You can achieve delta-neutrality by combining long and short positions in the futures, or options markets. For example, you can hold a long position in Bitcoin and hedge it with an equal and opposite short position in Bitcoin futures or perpetual swaps. Delta-neutral strategies are best for minimizing risk from small price fluctuations while still profiting from volatility or other factors like funding rates.
5. Cross-Asset Hedging
Hedging your crypto position with another correlated or inversely correlated asset is called cross-asset hedging. For example, you can hedge a long position in Bitcoin by shorting a related altcoin, such as Ethereum. Alternatively, if you’re bullish on crypto but worried about short-term volatility, you could hold Bitcoin and hedge it with a short position in a traditional asset like gold, which often moves inversely to crypto. This technique is great for diversifying risk across different asset classes or hedging exposure to correlated cryptos.
6. Stablecoin Conversion
If you’re concerned about crypto market volatility or an impending price drop, you can convert your holdings into stablecoins. This preserves your portfolio’s value in a stable asset without exiting the crypto ecosystem. It’s best for short-term hedging against market volatility or securing gains without cashing out to fiat currency.
7. Covered Call Strategy
The covered call strategy involves holding a crypto asset, Bitcoin for example, and simultaneously selling a call option on that asset. You keep the premium from selling the call option, which can offset any downside movement in the underlying asset. If the price stays below the strike price, you keep both the premium and your crypto. If the price exceeds the strike price, you’ll have to sell your crypto but still keep the premium. This hedging technique is best for generating income while holding crypto, while providing the option of selling at a higher price.
8. Funding Rate Arbitrage (Perpetual Swaps)
Perpetual swaps have funding rates that can either earn or cost you money depending on the prevailing market sentiment. You can take advantage of funding rates by hedging your long or short positions based on whether funding is positive (longs pay shorts) or negative (shorts pay longs). For example, if funding rates are high, you can hedge a long position by shorting perpetual swaps to earn the funding fee. Funding rate arbitrage is great for minimizing the cost of holding positions or earning passive income through funding payments.
9. Crypto Index Hedging
You can hedge your market crypto position by shorting or using options on a crypto index, which gives you broader market exposure. This helps to reduce risk without having to short individual cryptocurrencies, especially when unsure about which asset will underperform. Consequently, hedging with crypto indices is great for reducing risk across an entire portfolio of cryptos without targeting specific assets.
10. Grid Trading
Grid trading is a method of placing buy and sell orders at predetermined intervals around a set price level. If you expect a volatile market but aren’t sure of the direction, you can hedge your position by setting both long and short orders at different price levels. This strategy helps you profit from price swings in both directions. This technique is great for profiting from a volatile, sideways-moving market without taking a strong directional stance.
Common Pitfalls and Mistakes
Trading crypto derivatives with leverage can be highly profitable, but it also comes with substantial risks. Many traders, especially beginners, fall into common traps that can lead to significant losses. It’s always great to safeguard your strategy when trading crypto derivatives with leverage, so let’s have a look at the most usual mistakes one can make.
1. Over-Leveraging
- Pitfall: Traders often use too much leverage, amplifying both potential gains and losses.
- Consequence: Even a small unfavorable price movement can lead to the liquidation of positions, causing traders to lose their entire margin.
- Solution: Use conservative leverage (e.g., 2x-5x) and ensure you’re familiar with how leverage magnifies both risk and reward.
2. Ignoring Risk Management
- Pitfall: Failing to set stop losses, position sizing rules, or account for the maximum potential loss.
- Consequence: A single bad trade can wipe out a large portion of your capital if you don’t limit your downside risk.
- Solution: Always set stop losses and use proper position sizing based on the amount of capital you’re willing to risk on each trade.
3. Lack of Understanding of the Instruments
- Pitfall: Entering leveraged positions in futures, options, or perpetual swaps without fully understanding how these instruments work.
- Consequence: Misunderstanding the mechanics can lead to unexpected liquidations, forced exits, or losses due to time decay in options.
- Solution: Educate yourself about the specific crypto derivatives you’re trading, including all relevant terms and conditions, and test strategies in a demo account before using real funds.
4. Failure to Account for Volatility
- Pitfall: Underestimating the extreme volatility of crypto markets while using leverage.
- Consequence: Rapid price swings can cause forced liquidations or massive losses, especially when markets experience sudden flash crashes or pumps.
- Solution: Adjust leverage according to market conditions, especially during periods of high volatility, and use wider stop losses or lower leverage.
5. Neglecting Funding Fees and Expiry Dates
- Pitfall: Traders holding leveraged perpetual swaps or futures positions may overlook the impact of funding fees or expiration dates.
- Consequence: Accumulated fees over time or the need to roll over contracts can erode profitability or create losses, particularly during long-term trades.
- Solution: Be aware of the funding rates in perpetual swaps and futures expirations, and consider these costs when planning long-term trades.
6. Holding Leveraged Positions During Low Liquidity Periods
- Pitfall: Holding leveraged positions during low liquidity times (e.g., weekends or holiday periods) can increase slippage and lead to unfavorable fills.
- Consequence: Thin order books may cause your orders to execute at worse prices, leading to larger-than-expected losses.
- Solution: Avoid high-leverage trades during periods of low liquidity, and use limit orders to control your entry and exit prices.
7. Ignoring the Impact of Liquidation
- Pitfall: Traders often focus only on profits and ignore the risk of liquidation, especially when using high leverage.
- Consequence: A rapid market movement can trigger automatic liquidation of positions, causing traders to lose not only the current trade but also additional fees and potential future profits.
- Solution: Keep your leverage in check, monitor your liquidation price, and ensure you maintain sufficient margin to avoid forced liquidations.
8. Not Hedging Properly
- Pitfall: Failing to use hedging strategies when taking on leveraged positions.
- Consequence: Without proper hedging, traders are exposed to significant directional risk, which can result in substantial losses during unfavorable market conditions.
- Solution: Use hedging strategies such as options, futures, or stablecoin conversion to mitigate risk and protect your leveraged positions.
9. Ignoring External Market Events
- Pitfall: Not paying attention to major macroeconomic or regulatory events that could impact the market.
- Consequence: Sudden regulatory changes, hack announcements, or large economic shifts can lead to extreme market volatility, which can devastate leveraged positions.
- Solution: Stay informed of macro events, news, and regulatory changes, and reduce leverage or exit trades ahead of potentially impactful announcements.
Regulatory Landscape for Crypto Derivatives
The regulatory landscape for crypto derivatives is evolving rapidly as governments and financial authorities around the world work to develop frameworks that balance innovation, investor protection, and market stability. Due to the decentralized and global nature of cryptocurrencies, regulatory approaches differ widely across jurisdictions, ranging from outright bans to full regulatory acceptance.
Financial markets across the EU are regulated by the ‘European Securities and Markets Authority (ESMA).’ Their governance includes overseeing crypto derivatives trading, as the MiCA regulatory framework (Markets in Crypto-Assets) aims to provide clarity for crypto assets and related products across EU member states.
Regulations across Africa vary significantly, with some countries embracing crypto and others banning it. For example, South Africa allows the trading of crypto derivatives under certain conditions, with platforms required to comply with Financial Sector Conduct Authority (FSCA) guidelines. Starting October 2022, crypto assets have been classified as financial products by the authority, having the regulatory framework described in the Financial Advisory and Intermediary Services Act (FAIS).
In this part of the world, brokers and institutions offer crypto market access under the supervision of stringent regulatory bodies. In Japan, for example, crypto derivatives trading is overseen by the Financial Services Agency (FSA), which provides one of the most robust regulatory frameworks for digital assets. Trading platforms must be registered with the FSA and comply with KYC (Know Your Customer), Anti-Money Laundering (AML) and capital requirements to operate in this country.
Brokers operating in Singapore must abide by the regulations imposed by the Monetary Authority of Singapore (MAS). It regulates all financial products and allows crypto derivatives trading through licensed companies that comply with local regulations. There are no specific leverage restrictions, but platforms must follow general risk management guidelines.
Hong Kong has their financial services regulated by the Securities and Futures Commission (SFC). The SFC requires platforms offering crypto derivatives to register and follow strict guidelines similar to those for traditional financial products. As of 2020, the financial authority enforces regulations requiring all crypto platforms operating in this country to comply with securities laws.
Even though crypto trading across Southeast Asia is widely accepted, China has taken one of the strictest approaches globally, banning all forms of cryptocurrency trading in 2021. Imposed by the People’s Bank of China (PBoC), this ban extends to both domestic exchanges and foreign platforms operating in the country.