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Why Are Crypto-Derivative Markets Essential?

2021-08-26

TL; DR:

  • Derivatives allow investors to diversify their portfolios and expose themselves to various cryptocurrencies.

  • Derivatives are useful in safeguarding a portfolio from extreme price volatility and unexpected risks.

  • Derivatives are essential because they promote price discovery. With optimal price discovery, market participants know that all relevant information has been incorporated into the asset's current price, improving price dependability.

Crypto-derivatives is a fast-growing market that attracts trillions in volume every month. Much like traditional derivative markets, crypto derivatives have an essential role in the crypto industry. Hence, it is no surprise that many crypto exchanges and markets have adopted platforms for traders to enter the derivatives markets. 

In this article, we will look at what a crypto-derivative market is and explain why it is essential to the crypto economy.

What are derivatives?

Unlike a spot trade, a derivatives trade does not directly involve the asset. Instead, a derivatives trade is a financial contract based on the speculated future value of an underlying asset. The perceived difference between the value of an asset’s current and future is what provides the market with liquidity, hedging, and arbitrage opportunities. This means there can be substantial opportunities for financial gains as much as it is for potential losses. As such, it’s crucial to understand how these trades work and why they’re important.

Learning how to trade a crypto derivative will lead you to understand how and when it’s best to short or long an asset. A trade that ‘shorts’ an asset like Bitcoin involves speculation or belief that the asset is going to fail in the short term or at least fall by some amount. Longing is the opposite, in that there is a belief the asset will perform positively in the long term. These two options allow investors to make decisions in the derivatives market that are unavailable to a spot trader. For example, they enable traders to make profits even when the underlying asset is performing poorly. As such, derivative markets are not only a tool for speculating the future direction of an asset, they are also instruments that help protect from capitulations and volatile market movements.

Another key feature of derivatives is leverage. Leverage is an essential tool across traditional and cryptocurrency markets. It allows for better capital efficiency as traders do not have to lock up entire amounts of capital. As the use of leverage increases both potential returns and risks, users must always exercise caution. Therefore, traders should use a leverage amount that suits them. For example, if you're conservative or new to cryptocurrency trading, a 5x or 2x leverage would be appropriate.

These aspects combine to make derivatives a sophisticated trading tool for investors that allows them to speculate and even protect their portfolios.

Why are derivatives important in the crypto economy?

Crypto-derivatives are a pivotal component of the crypto economy for a few reasons. Firstly, derivatives allow investors to diversify their portfolios and expose themselves to various cryptocurrencies. With derivatives, investors can create sophisticated strategies such as pairing or arbitrage trading.

Secondly, derivatives are useful in safeguarding a portfolio from extreme price volatility and unexpected risks. As alluded to earlier, derivatives such as futures and options allow a trader to ‘short’ an asset, which means to bet on prices to fall. Without a derivatives market, a long-term investor who owns a portfolio of crypto assets cannot protect it in bear markets.

The third reason why derivatives are important is that they promote price discovery. Price discovery is the process of determining the value of an asset. It is determined by a number of variables, ranging from market liquidity to information flow.

By allowing investors to go long and short, price discovery may become more efficient, resulting in smoother market adjustments. With optimal price discovery, market participants know that all relevant information has been incorporated into the asset's current price, improving price dependability. 

Applications of derivatives

Utilizing derivative trades allows for financially strategic actions that can help a trader realize larger profits, protect a portfolio or compensate for other assets within a portfolio, and assist miners in hedging against various risks.

Hedgers

One of the most common uses for a derivatives trade is to hedge against volatility, down-trending markets, or any other movement in price action that would otherwise harm a portfolio. As noted previously, if Bitcoin were to drop in price, a derivatives trade that shorts the crypto (expects it to decrease in price in the short term) would be successful. This is because the trade does not hinge on an actual asset’s performance but is a contract based on speculation of an underlying asset.

Speculators

Speculation, therefore, is another accepted use for a derivatives trade. As a market, the amount of short and long positions can be tracked. When coupled with price action and industry developments, this information can become useful insight into the prevailing market sentiments. Thus, speculative trading positions can assist traders in forecasting the future movements of the market and expressing what they think the market value should be. From a professional derivatives trader’s perspective, they are managing speculative opportunity and risk as a portfolio.

Miners

Crypto derivatives can also be used by those working directly in the industry as well. For example, Bitcoin miners might want to participate in the derivatives market to protect the portfolio of their mining operations. As more miners set up operations, and as time goes on, the available hash rate and Bitcoin’s mining difficulty will automatically adjust to fit everyone in. This means the value in mining will slowly dissipate over time. Technological improvements in mining computers can also give advantages to a minority of miners and cost the majority till they can catch up. A derivatives trade can act as a hedging device for miners, just as it can protect the average trader. 

Conclusion

The derivatives market can have a strong effect on the overall crypto economy, evidenced by the aforementioned players that generally participate in these markets. Beyond portfolio management, derivatives are a driving force in helping the crypto industry become a legitimate asset class. As more traders join the crypto derivatives market, liquidity in crypto markets increases, allowing traders to transact in the market in the most cost-efficient manner.

To learn how to start trading in a derivatives market and how to do so responsibly, Binance Academy offers several articles and guides on responsible trading. To get started with trading, register at Binance.com and invest wisely!

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