In this article, I will explain what a derivative is, how does it help you, and the types you can choose from.
What Are Derivatives?
Derivatives represent financial contracts between at least two parties based on the future price of an underlying asset. They have been a part of traditional markets since at least the Middle Ages, but their modern form came to be in the late 1970s.
Derivatives can be of different types, like futures, forwards, and options, with their basis being several assets, like stocks, bonds, or currencies.
In the crypto world, Bitcoin futures were the first to reach a wider audience and they are still the most traded to this day.
Why Would You Use Derivatives?
Derivatives are highly important when it comes to being used to hedge risk or speculating on the price of the underlying asset in case it experiences changes.
If an investor wants to enjoy protection against changes in price, signing a contract which would allow them to acquire an asset for a fixed price would downplay the risk a lot.
Furthermore, derivatives can also be used for speculation, allowing traders to try to predict how will the price of an asset change in time.
How Many Types of Derivatives Are Out There?
Derivatives have four types: futures, forwards, swaps, and options.
Futures and forwards are very much alike, except for the fact that futures require the buyer to acquire the asset at a price that was previously agreed-upon, while forwards are more flexible and can be designed to fit the needs of both parties.
Swaps are mostly used between two parties in order to exchange one type of cash flow for another
Options give the buyer the chance of acquiring or selling the underlying asset at a certain price, but the trader is not required to buy the asset, thus representing an important difference between the first two types.
How Can You Use Derivatives in Crypto Trading?
A futures contract, by default, really comes in handy when it comes to crypto. This allows important traders to reduce their risks by using a contract that settles directly to an underlying auction price of a certain crypto.
Using a strategy known as shorting, you can borrow the assets from a third party and sell them on the market if you believe the price is about to go down. When the price does go down, the trader can buy the same amount of assets back much cheaper, and the exchange receives its commision.