Crypto derivatives are financial instruments that derive their value from the price of underlying cryptocurrencies. Similar to traditional derivatives, they allow traders to speculate on future cryptocurrency price movements even without directly owning the assets. Let’s discuss four main types of crypto derivatives: futures, forwards, perpetuals, and options.

‍

1. Futures Contracts

Futures contracts are agreements to buy or sell a crypto asset at a certain price on a specified future date. They are the most commonly used type of crypto derivative. Traders can benefit from futures contracts in two main ways: They allow traders to profit from speculating on future price movements and serve as a hedge against market volatility.

Given the volatile nature of cryptocurrency, the prices of crypto assets in the future may be either much higher or lower than at present. If the market price of, say, Bitcoin is at $250,000 two years from now and you own a futures contract where you agree to buy Bitcoin from a seller at $100,000 on a specified date in two years, you can buy the crypto at less than half the market price and sell it at a profit. Conversely, if in two years, the market price is at $250,000 and you have a futures contract where you agree to sell Bitcoin at $300,000, you will also make a profit.

Futures are traded on cryptocurrency exchanges that offer futures trading, such as BitMEX or the Chicago Mercantile Exchange (CME). They can be traded on both regulated and decentralized exchanges. Prices are marked-to-market daily, or updated based on the current market price of the asset on a day-to-day basis. This ensures that the gains and losses from the contract are recognized and recorded at the end of each trading day to make it easier for traders to manage the risk associated with trading futures.

Futures are quite popular for allowing traders to use leverage—borrowing funds to have more capital to invest in hopes of earning a much larger profit than they would have on their own. (Read up on leverage trading here.) It’s important to remember that opting for high leverage increases both potential gains and the risk of significant losses. Traders should conduct thorough market analysis and risk assessment before attempting to max out leverage options.

‍

2. Forward Contracts

Like futures, crypto forward contracts are agreements to buy or sell a cryptocurrency at a future date for a price agreed upon today. However, unlike futures, forwards are not standardized and are not traded on centralized exchanges. Since they are less regulated, the risk for both parties is also greater, but on the flipside, they are also more customizable. Parties can agree on any amount of crypto at any price and at any specified date in the future.

For example, a mining company might agree to sell Bitcoin at $150,000 exactly one year from now. Even if the price of Bitcoin drops to $70,000 by that date, the buyer of the forward contract still has the right to sell Bitcoin at a rate of $150,000 to the seller of the forward contract.

The value of forward contracts is marked-to-market only once, at the contract's maturity, not daily like futures. Since the terms are already set, forward contracts don’t fluctuate in price.

Like futures, forwards can be very beneficial for investors who want to hedge against extreme price fluctuations in the highly volatile crypto market.

‍

3. Perpetual Contracts

Perpetual futures contracts, or perpetual swaps, commonly known as "perpetuals" or “perps” for short, behave like futures contracts without an expiration date.

For instance, you can have a perpetual contract that lets you sell Bitcoin to a buyer for $100,000. This will take into effect when either you want to sell or the buyer wants to make a purchase, whether in a year, two years, or at any time, depending on the terms of the agreement. Since there is no expiry date, a perp needs a mechanism to ensure that the price of the contract stays close to the market price of the underlying asset. Otherwise, if the market price of the underlying crypto asset soars very high or plunges extremely low in the future, either the buyer or the seller of the contract will end up losing a huge sum of money.

To avoid this, exchanges use a tool known as the funding rate mechanism, which adjusts the cost of holding a position (long or short) based on the swap's price relative to the spot price of the cryptocurrency. For instance, if Bitcoin's market price is $50,000, the funding rate mechanism ensures the price of the perpetual swap stays around around $50,000 by charging fees or providing rebates to traders. If the perpetual swap price is currently higher than the spot price (positive funding rate), traders with long positions pay fees to those with short positions. Conversely, if the perpetual swap price is currently lower than the spot price (negative funding rate), traders with short positions pay fees to those holding long positions. This helps to keep the price of perpetuals close to the actual market price of the asset they represent and ensures that perps remain fair trading instruments no matter how far into the future the contract remains active.

‍

4. Options Contracts

Options are complex derivatives that provide the holder the right, but not the obligation, to buy or sell crypto at a specified price (called the strike price) on or before a specified date. A call option lets you buy the asset at a certain price in the future, while a put option lets you sell the asset at a certain price in the future. Options are further classified in two ways:

• American, which can be exercised any time before expiration
• European, which can only be exercised on the expiration date

As with futures and perpetuals, options trading benefits traders who want to speculate on volatile price action without the risk of owning the underlying assets or investors who want to hedge against them.

The price of the options contract is called the premium. It depends on several factors, including market volatility, the length of time until expiry date, and the current price of the underlying asset. For call options, the premium is usually lower if the strike price is far higher than the current market price of the asset and higher if the strike price is lower than the asset’s current price. Meanwhile, for put options, the premium is lower if the strike price is much lower than the asset’s current market price, and higher if the strike price is much higher than the asset’s current market price.

Here’s an example of how it works:

If you expect the price of BTC to be at $120,000 in one year, you can buy a call option (the right to buy an asset at a specific strike price) at $70,000 with a premium of $1,000 per BTC. The price of the asset on strike date needs to surpass the strike price plus the premium in order for the call option to actually be profitable. Therefore Bitcoin must be at $71,000+ for you to exercise the call option. 

Let’s say you buy the call option on May 1, 2024. If the price on May 1, 2025 is at $100,000, you can exercise the call option to buy BTC at $70,000 per Bitcoin. If you buy 1 BTC, the total cost will be $71,000 ($70,000 + the premium of $1,000). Meanwhile, if the price on May 1, 2025 is $50,000, you don’t need to exercise the call option to buy BTC since you can buy it at $50,000—the current price point that is lower than the strike price of the call option. However, you will lose $1,000 because of the upfront premium you paid for the options contract.

Upon expiry date or whenever either the buyer or seller decides to close the option, the contract is settled in either cash or crypto. Again, you are not required to buy or sell the crypto asset; you merely have the option to do so. And if your price prediction turns out to be very far from reality, then what you spent on the premium will be wasted as you will be left with an option you don’t need to use. To avoid this, many traders use a combination of call and put options and a variety of trading strategies to protect their funds.

As you can see, each type of derivative comes with its own set of opportunities and challenges. And although crypto derivatives can help traders maximize profits and hedge against risks in the very unpredictable crypto space, they require a deep understanding of market dynamics and risk management strategies to be truly effective.

P.S. If you want to learn more about crypto trading, check out Bitskwela’s trading and investment module!

‍