When I finally bit the bullet in 2018 and decided to buy Bitcoin, my expectations were…optimistic. I thought that the moment I registered on Binance, a giant green button with the words ‘Buy here’ would appear. Crypto was raw tech after all, so it only made sense someone would hold my hands as if I were strolling through Facebook or Twitter for the first time. But it wasn’t anything like that.
My dictionary, barren of financial mumbo jumbo, soon clashed with an alien language. Spot, futures, options, derivatives – these words made no sense. Ashamed, I returned the money I was about to throw at my screen back into my wallet. I was dumbfounded. Wasn’t crypto the antithesis of banks? Why is it overcomplicated with Wall Street jargon?
Money hasn’t changed one iota since we invented it, and neither have the financial instruments traded by bankers in New York and London. If bankers can make more money by trading complex financial products, why shouldn’t crypto investors do the same? Buying and selling spot contracts is perhaps enough for the average person, but that doesn’t mean we run away from advanced derivatives that help us make more money than we otherwise would.
If crypto is the future of finance, it should offer everything traditional finance does. And if you want to understand what you’re trading, it’s time to learn about derivatives.
What are Derivatives?
Derivatives are the simulacrum of financial markets. They are contracts representing the value of an asset, metal, or stock. Investors trade derivatives when they want to trade contracts instead of the underlying asset.
You might wonder, isn’t it better to own the real thing?
Take gold for example – a physical asset with high value. You need a safe place to store gold, and if you ever want to liquidate your gold bars, you need a buyer near you. Trading gold like you would trade AMD shares through a broker is out of the question. It would be too time-consuming and hectic compared to trading a contract. You’d have to drive back and forth to your local pawn shop. But hey, I won’t judge if you’re slowly accumulating in hopes of becoming Scrooge McDuck someday.
Can you think of anything else that’s a highly-traded derivative and retail investors rarely own? Bingo, oil. You’re probably not the leader of a leading oil importer like China, Germany, or the U.S. You don’t need oil for the sake of owning or stockpiling oil. And unless you happen to have an Olympic-size swimming pool in your backyard, you likely don’t have enough space nor the logistical prowess to trade oil as quickly as with derivatives.
What seems to be the recurring issue here? Mobility. Open an exchange platform, and you’re a few clicks away from buying or selling contracts. And the exchange is happy to offer you leverage so that you trade more than you own. That’s the power of derivatives, and you won’t find it at any other market. Owning the real thing is great for long-term investors, but you’re here to trade and make money.
Types of Derivatives Contracts
Spot, futures, options, CFDs, etc. It’s enough to make your head spin. And it’s not like you can take a leap of faith and trade whichever contract you feel like trading. Remember when oil went negative in 2020? Naive investors thought they were getting paid for clicking the buy button. But nope, they were under the contractual obligation to store the oil they bought. How many oil barrels can fit in your apartment?
To avoid laying in bed side to side with a bunch of oil barrels, you have to know your contracts. Various derivatives contracts exist, but before we go further, let’s learn more about spot markets.
A spot market is an ordinary financial market where investors trade assets. Buyers swap dollars for Bitcoin, and sellers swap Bitcoin for dollars. The spot price is the real price at which traders buy Bitcoin. And unlike derivatives, spot buyers own the asset and not a synthetic token that represents its value.
Spot markets are where investors buy cryptocurrencies to hold them for the long term. You can trade assets on a spot market, but the lack of leverage limits your profit. What are the benefits of spot markets? They are safer (no cascading liquidations that influence price) and the exchange can’t liquidate your position.
Did you know that rice used to be Japan’s medium of exchange 300-years ago? Or that the Shogunate paid the wages of the Samurai in rice and not coins? Now think of the possible outcome when a warrior class trained to kill suddenly faces poverty because a drought ruined the nation’s annual rice production and supply.
The Dōjima Rice Exchange in Osaka introduced the world’s first futures market and revolutionized Japan’s economy. Everyone, including the Samurai, shifted from rice to coin. The markets enabled farmers to sell their produce at a fixed price during a quarter, removing the burden of volatility they encountered as sellers.
Before Futures were a thing, only commodity sellers suffered from volatility. However, futures forced buyers to accept both the rewards and risks of volatility. But what is a futures trade? It means that buyers purchase commodities at a certain price and that sellers deliver them upon the contract’s expiry.
In modern times, investors trade futures to hedge against assets or speculate their value. The crypto market offers perpetual contracts (futures with no expiry date). Exchanges settle these contracts in cash, and without an expiry date, both sides agree to fund the market by paying a fee called the funding rate.
The funding rate is an eight-hour time window during which exchanges calculate an interest rate based on the premium between Bitcoin’s futures price and its underlying value. Both the exchange and market side (that wasn’t charged) receive a portion of the fees.
For example, whenever the futures price is higher (positive funding rate), buyers pay the interest fee to the sellers. Sellers have to pay the fee when the price is lower than Bitcoin’s spot price (negative funding rate). The fee you pay or earn depends on your position value and funding rate. You can calculate it by multiplying the two.
Positive and negative funding rates sometimes indicate the market’s direction. This is normal as funding rates incentivize traders to turn into the counterparty and open a position in the opposite direction to earn fees. However, extreme funding rates indicate an oversold or overbought market state.
Inverse or USD Contracts?
There are two types of futures markets in crypto: coin marginated and USD marginated futures.
USD marginated futures settle contracts in stablecoins like Tether. You open a position with USDT and leave with USDT after closing it. These contracts favor bearish traders who want to short because they remain in stables throughout the trade.
Coin marginated, also known as inverse futures, are contracts that settle trades in coins. You deposit Bitcoin, trade Bitcoin, and leave the trade with more Bitcoin. These contracts favor bullish traders who believe in a bullish market. Your returns multiply because you keep the original deposit and gain returns in the same asset, which has appreciated in value.
Spot markets like Binance’s BTC/USDT pair offer margin trading. You can buy more Bitcoin by loaning money from the exchange. However, spot markets limit the maximum leverage to five or ten times your initial deposit.
Futures markets have different rules. Their leverage goes up to 100 or 200 times your deposit. But since futures markets are more volatile, the chance of having your account liquidated is also higher.
Unlike futures, options markets do not impose the obligation to buy or sell a commodity during a certain period. But traders have the right to do so if they wish.
Let’s say there’s a Bitcoin Options contract for the first quarter in which sellers wish to sell the asset for $60,000. The buyers pay a $1,000 premium to have the option to buy Bitcoin for the given price until the end of March.
If Bitcoin reaches $70,000 by the quarter’s end, the buyer obviously wants to buy. He pays the $1,000 premium to exit with $9,000 in profit. But the buyer won’t exercise his right if Bitcoin ends up costing $50,000. He’d not only have an immediate 16% loss but also have to pay the premium.
The seller has a different situation. He is only in profit when the buyer refuses to buy since the seller takes his premium. But when the buyer buys the asset, the seller suffers an opportunity cost as he could have sold the asset for a higher price.
Buyers have much more flexibility in options markets because the premium is fixed, but the reward is limitless. Sellers face limitless losses and fixed rewards, much like their Samurai ancestors.
Which One Should You Trade?
Spot, futures, and options markets are radically different. Choosing which to trade depends on your risk appetite and expertise. Beginners should stick with spot trading and use it as a sandbox before advancing to other markets. However, those experienced with futures should experiment with options (and vice-a-versa) to determine which style suits them best.
If you want to learn more about derivatives, explore the following links: