Derivatives, or financial contracts whose value is derived from some underlying asset, have existed for thousands of years. They offer day traders an opportunity to gain exposure to an asset without directly owning it. In the world of crypto (though we will only focus on Bitcoin in this article), the two primary classes of derivatives are futures and options.
Futures is a derivative contract agreement between two parties such that the underlying asset–which could be, say, Bitcoin–is traded at an agreed-upon date for a predetermined price. On this expiration date, the buyer is obligated to buy the asset, and the seller is obligated to sell it.
When one buys a futures contract, he is entering a “long” position. When sells a futures contract, he is entering a “short” position. Those who go long enjoy a profit when the underlying asset’s market price is greater than the price set by the contract. Meanwhile, those who go short enjoy a profit when the market price is below the price set by the futures contract.
When traders exchange money during futures trades, they do not always pay the full amount. Rather, they may borrow some fraction of the amount owed from an exchange. This lets them employ leverage, which boosts potential profits but also potential losses.
Perpetual futures are futures contracts that do not have an expiry date. That is, a trader may retain the contract for an arbitrary amount of time until they close it out or have no choice but to liquidate.
Bitcoin options are a derivative contract such that the owner of the derivative is allowed to purchase or sell the underlying asset (Bitcoin) at a predetermined price (the “strike price”) until an established terminal date. Options come in two forms: call options and put options. Both may be long or short, as described above. Options are considered leveraged, since the owner pays much less to buy it than the contract is worth.
Bitcoin derivatives, like derivatives across other fields, are used to both hedge and speculate.
Hedging is a means by which traders mitigate risk. Bitcoin is notoriously volatile, and a trader may employ Bitcoin derivative instruments in order to shield himself from said volatility.
Speculating is when a trader takes action in the derivatives market based on the belief that some asset’s price is going to rise or fall. If a trader thinks that Bitcoin is about to go on a bull run, he could apply leverage in order to magnify the presumed gains.
Some people criticize the entire derivatives industry because it is just ‘playing with money’. But this undervalues the role that trading plays in price discovery. No asset has an intrinsic price–all prices are predicated on the supply and demand for that asset. Since it is impossible to access the distributed knowledge of every individual’s supply and demand, and because supply and demand and constantly changing, free trade is how we discover asset prices. Derivative trading accelerates this process.
Still others think that, on a Bitcoin standard, the derivatives market will die, since the cost of speculation will rise. While it is true that people will feel less pressure to outpace inflation, there will always be those who want to try to outpace the steady appreciation of the next global reserve asset.
There is nothing wrong with using financial instruments. On the contrary, they are pivotal to rapid price discovery.
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