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Crypto Derivatives, A Short Guide to A Growing Trade (pun intended)

CoinMarketCap has now expanded its listing to include crypto derivative market data. If you are interested to learn more about this growing trend in the crypto universe, here is a short introduction to crypto derivatives, and more specifically, the perpetual swap.


Key Takeaways

  • Crypto derivatives are financial products that have their value derived from an underlying cryptoasset, e.g. Bitcoin. 
  • They commonly come in two forms: futures and options. Both are agreements to buy or sell a certain quantity of a cryptoasset (e.g. 1 Bitcoin) for a certain price some time in the future. 
  • The biggest benefit of crypto derivatives is that they allow traders to take on more exposure (i.e. potential gain or risk) to the underlying cryptoasset than the amount of capital they currently own. It is, however, important to be mindful of the perils of over-leverage.
  • Crypto derivatives also allow more complex strategies to be executed. This allows for greater flexibility and convenience in execution as compared to spot margin trading.

Introduction to “crypto derivatives”

A crypto derivative is, simply defined, a financial product with a value that is derived from an underlying asset. Most of you are already familiar with crypto spot prices — the price of BTC, ETH, XRP etc. against the USD. Derivatives are instruments that use these prices and allow traders to execute leveraged positions for hedging of risks or for profit.

There are two main types of derivatives that currently exist in the crypto space: futures and options.

Futures

Futures contracts are an agreement to buy or sell a set quantity of an underlying asset at a specific future date, at the traded price. Hence, all futures have an expiry date that denotes when the buyer and seller of the futures contract settle their outstanding positions. The perpetual swap is a variant of futures, with the difference being the removal of the expiry date — hence its name, “perpetual swap.”

Options

Options are an instrument that gives the buyer the right (not the obligation) to buy or sell the underlying asset at a specific price at a specific time (European-styled options). Conversely, the seller has the obligation to deliver the asset should the buyer choose to exercise his or her right to buy. 

There are two types of options: calls and puts. The buyer of the call (put) option can choose to exercise his or her right to buy (sell) the underlying asset at the defined strike price from the seller of the option at expiry.

Why trade the perpetual swap (instead of spot)?

Even though the prices of the perpetual swap are designed to mimic spot prices, the perpetual swap offers traders three main benefits over spot trading:

  • The ability to use leverage cheaply and easily
  • The ability to “short” an asset without much hassle
  • Liquidity on perpetual swaps is usually much higher
Benefit 1: To use leverage cheaply and easily

All perpetual swap products in the cryptocurrency space allow traders to easily utilize high leverage. Leverage refers to the ability to gain additional exposure to the underlying asset with the same amount of initial capital.

Example:

Exchange A allows traders up to 100x leverage. This means that the trader only needs to deposit 1 BTC worth of collateral to control up to 100 BTC worth of exposure. However, trading with such high leverages is not recommended, as price only needs to move less than 1% against you for liquidation to occur. Given the highly volatile nature of cryptocurrencies, this scenario is not unlikely.

Most spot exchanges that offer margin trading do NOT allow such high leverages (the maximum is usually 5x leverage). And in those cases where higher leverages are allowed, the exchange requires you to take out a margin loan for the asset you wish to leverage on, making the entire process cumbersome.

Perpetual swap products remove the need for taking out a margin loan, as leverage is built into the product, resulting in a fuss-free experience for traders.

Benefit 2: To “short” an asset with little hassle

In order to “short” (betting that an asset’s price decreases without owning the asset) a spot asset, all spot exchanges that allow margin trading require you to borrow the asset (for a fee), go into the exchange, and sell it. These requirements make short selling assets inconvenient and potentially expensive. In addition, not all spot exchanges have margin trading facilities, which makes short selling on these exchanges impossible.

The perpetual swap changes the process by making it as easy to short (sell) the asset as it is to long (buy). Simply enter the quantity, price and direction (long or short) and you will be able to get the exposure you desire. 

Benefit 3: Liquidity in crypto derivatives is much higher than in spot markets

Due to the high amounts of leverage that these products have, coupled with the ability to long or short without hassle, liquidity on perpetual swaps is much higher. Being able to utilize high amounts of leverage means traders can post larger order sizes with less collateral, which makes markets more liquid. In addition, as traders can short the asset without the need to borrow the asset, traders can post sell orders easily. 

In general, liquidity in perpetual swaps is much higher than what is available in spot markets, and traders can now execute trades for much larger sizes with less slippage, making these markets preferable to spot markets for trading.

How does leverage work?

As mentioned previously, crypto derivatives allow traders to take on more exposure to the underlying asset than the amount of capital they currently own. This is the main difference between trading a crypto derivative like the perpetual swap versus the spot asset.

Comparison of spot margin trading and derivatives

While margin trading does exist in spot markets and exchanges (like Bitfinex, Binance or Huobi, amongst others), the maximum leverage traders can achieve on these markets tops out at 5x, as noted above. The most commonly traded perpetual swaps in the majority of exchanges commonly allow traders to leverage 50x to 125x. While it is never recommended to utilize such high leverages when trading a volatile underlying like Bitcoin, crypto derivatives allow traders the flexibility to achieve high leverages should they choose to do so.

In addition, when margin trading on spot exchanges, traders are required to take a “loan” on the asset they wish to sell. For example, if a trader wishes to margin long BTC/USDT, they would first need to take a loan of USDT, and then proceed to buy BTC by selling USDT. Upon closing the trade (for profit or loss), they would then need to repay the loan that they initially took out. This is a more involved process than trading crypto derivatives, where the steps of opening and closing the loan are removed.

The fewer steps required to trade crypto derivatives makes the experience much more flexible and hassle-free for traders that wish to take on more exposure to the underlying asset than the capital they currently own.

What does “100x” leverage really mean?

The number that exchanges present when describing their crypto derivative product is the maximum leverage an exchange allows a trader to utilize when opening a position. This number also describes the minimum margin (or collateral) a trader needs to put up when opening a position.

Example:

Exchange ABC allows traders 100x leverage when trading their BTC/USD perpetual swap. Alice deposits 0.1 BTC on Exchange ABC. Alice decides that she is extremely bullish on BTC/USD and wants to fully utilize her 0.1 BTC asset for a 100x leverage and go long. This means that she can control up to 10 BTC (0.1 * 100) of a position with her initial deposit if she chooses to do so.

Alice will now make or lose $10 for every $1 movement in BTC/USD’s price. To give an example scenario:

– Alice takes a long position on BTC at an entry price of $10,000
– Alice’s collateral: 0.1 BTC (valued at $1,000 at current price)
– Alice’s leverage: 100x
– Alice’s position: 10 BTC

If BTC price rises to $10,100 (1% increase in price), Alice would have made $10 x $100 (from the price increase) = $1,000.

Notice that in this scenario, Alice has effectively doubled her initial capital.

So, what are the downsides of leverage?

While the example above seems appealing (to be able to control 10 BTC of risk with merely 0.1 BTC in collateral), the risks of such a move cannot be overstated. Putting on a highly leveraged position also means that if the market moves against her just a tiny bit, her position will be subject to liquidation and she will lose her entire collateral.

Utilizing the same example scenario above:

– Alice (long) entry price: $10,000
– Alice’s collateral: 0.1 BTC (valued at $1,000 at current price)
– Alice’s leverage: 100x
– Alice’s position: 10 BTC

If BTC falls to $9,900 (1% drop in price), Alice would have suffered $10 x $100 (from the price drop) = $1,000.

Notice that in this scenario, Alice has effectively lost her initial capital.

If the market trades against her by just 1%, her position would hit its bankruptcy price, i.e. the price at which her collateral would be fully used to cover the losses that she has sustained. This will result in her position being liquidated.

Do note that some exchanges have a liquidation price calculated separately from their bankruptcy price. A more aggressive liquidation price ensures that the collateral posted is sufficient to cover the losses sustained when the position moves adversely. This price is always triggered before the bankruptcy price, which means that the market may move less than 1% against Alice before she loses everything!

A position’s liquidation price is further (from entry price) the lower the leverage used. As a simple way to estimate how far the market would need to move against you before being liquidated, use this simple formula:

Distance from Liquidation Price = (1 / Leverage Used)%

The smaller the leverage used, the further the liquidation price. For example, if Alice chose to use a more prudent 10x leverage instead, her liquidation price would be ~10% away from her entry price, which means that she would not be as easily liquidated as if she used 100x.

Leverage is a double-edged sword

Leverage, in the right hands, can be an extremely effective way to utilize capital and maximize profits in trading. However, always be mindful of the perils of over-leverage. Picking the right direction will not result in profit if your position is liquidated due to the volatility of the markets. Keeping leverage in check is the best way to ensure that you do not get shaken out of your position before it comes into fruition.

Gerald is the Head of Research at CoinMarketCap. He started his career as a professional derivatives trader in the traditional markets, trading bond and commodities futures. He saw the trading opportunities that existed in Bitcoin Futures and Swaps and co-founded Hashtag Capital, a BTC-based hedge fund in 2018. Hashtag Capital was subsequently acquired by CoinMarketCap in mid 2019.

4 comments on “Crypto Derivatives, A Short Guide to A Growing Trade (pun intended)

  1. Interesting. Am just learning so not about to use this, yet!

  2. Great explanation, thanks, what markets do you recommend for swap?

  3. super interesting topic, great content.

  4. very well written short guide about crypto-derivatives. learned something different with examples about futures, options and swaps contracts in context of cryptocurrency and the way leverage can be utilized to maximize profit. Looking forward for more articles.

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