Derivatives

What Are Derivatives

A crypto derivative is a blockchain-run product that derives its value from an underlying asset. 

We have been using derivative contracts to offset losses for many years. The buyer and seller strike a derivative agreement with contradictory predictions about the underlying asset’s future price. Let's say you are a farmer. You anticipate that the price of a crop will go down by the time you harvest. You can’t afford to take risks, though. In that case, you can sell futures derivatives now for a price you aim to get for the crop. If the price decreases as you predicted, you earn a profit from the derivatives assets. If the price goes up, you make a profit from your harvests. In both cases, you offset the losses and earn a predictable income. 

It comes as no surprise that derivatives have made their way into the crypto market. They are available on many popular centralized and decentralized exchanges.

Summary of Important Points

• Crypto derivatives tokens are digital assets that derive value from underlying crypto or real-world assets.
• Common crypto derivatives are futures, options, and perpetual contracts.
• Crypto futures give investors exposure to an asset without purchasing it. 
• Crypto options give the right, but not the obligation, to buy or sell the asset for a predetermined price at a later date. 
• Perpetual contracts are derivatives without an expiry date. 
• Derivative contracts help generate liquidity, hedge against market volatility, and optimize price discovery.
• They can be risky for inexperienced traders. 

Different Types of Derivatives

Crypto derivatives can be divided into three: 

Crypto Futures

In crypto futures, two parties agree to purchase or sell an asset in the future. That is, you bet on the future price of the asset without actually owning or holding it. While the settlement date and price are predetermined in all futures, other conditions can be customized. Depending on the price changes, one party gains while the other loses. 

Crypto Options

Crypto options work similarly to crypto futures. However, as the name implies, here, the trader has the option to not move ahead with the transaction at a future date. They grant the right to buy or sell the asset, but not the obligation. A call option allows you to buy, and a put option allows you to sell an asset when you choose to.

Perpetual Contracts

Unlike crypto futures or crypto options, perpetual contracts don’t have an expiry date. You can keep your position open as long as you want by making periodic payments called funding rates. 

Advantages of Derivatives

Generate liquidity: Crypto derivatives assets create market liquidity. They facilitate the fast transaction of orders without taking a toll on the underlying asset's price.

For example, synthetic derivatives allow users to profit from the price movements of popular cryptocurrencies as well as fiat currencies, stocks, and commodities while not leaving the crypto ecosystem. 

Hedge against market volatility: Derivatives help offset losses when dealing with highly volatile markets. It will encourage institutional and professional traders to look into crypto with minimal risks. They give you access to many real-world and crypto markets without holding the underlying asset.

Healthy price determination: Crypto derivatives tokens can shape the price dynamics of the general crypto market. They give better flexibility to traders, thus optimizing price discovery and creating an efficient market. 

Nurture innovation: DeFi opens up the derivative market in a transparent, permissionless way. Anybody can mint a synthetic token using open-source protocols like Synthetix and Mirror without the intervention of a centralized institution.  

Disadvantages of Derivatives

Speculative: Derivatives are tools of speculation; their inherent unpredictability can harbor significant losses. 

General risks: The supply and demand of the underlying asset influence the price of derivatives. When leveraged, the risk multiplies. 

Counterparty risks: In the case of Over-the-Counter (OTC) derivatives, the risk of the other party not fulfilling their part of the agreement can't be ruled out.

Steep learning curve: Since derivatives trading involves complex concepts, it can be detrimental for amateur users in the fast-moving crypto market.