What Are Crypto Derivatives? Futures, Perpetuals, and Options
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Crypto derivatives are financial contracts whose value is based on an underlying cryptocurrency. They allow you to speculate on the future price movements of cryptocurrencies without owning the actual asset. Common types include futures, options, and perpetual contracts. These instruments offer leverage, risk management tools, and the ability to hedge against price volatility. They also provide flexibility for both long and short positions, enabling profits from rising or falling markets.
- Key Takeaways
Crypto derivatives allow you to speculate on the price of cryptocurrencies or hedge against market volatility. They provide a way to manage risk without directly owning the underlying asset. - Investing in derivatives can be done by registering on well-known exchanges, such as Kraken.
- Leverage can amplify gains and losses, making it crucial to understand margin requirements and risk management strategies when trading derivatives.
Types of Crypto Derivatives
Crypto derivatives are financial instruments that derive value from an underlying cryptocurrency, such as Bitcoin or Ethereum. They offer more flexibility in managing risk, speculating on price movements, or hedging against market volatility.
Understanding the different types of crypto derivatives is crucial, as they can be used to amplify gains, limit losses, or stabilize investment portfolios. With the rapid growth of the crypto market, derivatives have become increasingly popular among individual traders and institutional investors.
Several types of crypto derivatives are available, each serving different trading purposes. These include:
- Futures contracts
- Perpetual contracts
- Options
- Swaps
- Leveraged tokens
- Contracts for Difference (CFDs)
- Forward contracts
- Binary options
Each derivative type has unique features that cater to various trading strategies and risk profiles.
Here, we will focus on the three most commonly used derivatives: futures contracts, perpetual contracts, and options. These are widely accessible and offer a solid entry point for new and experienced crypto market traders.
Crypto Futures Contracts
In the case of future contracts, the buyer and the seller agree to make the transaction at a set price with a specific settlement date. Futures allow you to speculate on the future price of digital assets like Bitcoin without owning them. They are used for speculation and hedging against price volatility, allowing you to profit from price movements.
The main aspects that a futures contract must have to work are:
- Contract expiration: A set date when the contract must be settled
- Units per contract: The amount and value of each contract
- Physical delivery vs. Cash settlement: You will decide whether to pay for the derivative in fiat currency or crypto.
- Leverage: Allows you to maximize returns but increases risk. This element is optional, so you can choose to use it.
To open a position in a futures contract, you must deposit an initial margin, a percentage of the contract’s value. To keep the position open, you must maintain a certain amount in the account, known as the maintenance margin. If the balance falls below the crypto margin, you must deposit more funds or face liquidation of the position.
Long vs. Short Positions in Futures Contracts
In a long position, you expect the cryptocurrency price to rise by the contract’s expiration. If correct, they profit by buying the asset at the agreed-upon lower price and selling it at a higher market price.
In contrast, a short cryptocurrency position is taken when you expect prices to fall. You agree to sell at the contract price, hoping to buy it back at a lower price later. Both strategies allow you to benefit from price movements but carry risks if the market goes in the opposite direction.
For example, assume you go long on a crypto futures contract, with ETH as the underlying asset, for $2,000. On the other side of the trade is your friend Ben, who holds the short position. We’ll ignore the effect of margin and leverage in this scenario for simplicity.
If the price of ETH increases, you stand to profit, while Ben will face losses. Conversely, Ben would benefit from the short position if the price falls, and you would incur losses.
| ETH price at settlement date | $3,000 | $1,700 |
|---|---|---|
| You (long) | Gain $1,000 | Loss $300 |
| Ben (short) | Loss $1,000 | Gain $300 |
Pros
- Potential for high profits through speculation.
- Ability to profit from both rising and falling markets.
- Leverage amplifies potential returns.
- Useful for hedging existing positions against price volatility.
Cons
- Leverage increases the risk of significant losses.
- Volatile markets can lead to margin calls or liquidation.
- Requires close monitoring and active management.
- It is not suitable for inexperienced traders due to its complexity.
Crypto Perpetual Contracts
Perpetual contracts are similar to futures. The main difference is that it doesn’t have an expiration date. You can hold your position (long or short) indefinitely in perpetual contracts.
Since perpetual contracts don’t expire, exchanges use a funding rate mechanism. It keeps the contract price in line with the spot market price of the underlying asset. In contrast, futures contracts usually rely on the natural convergence of prices as the expiration date approaches.
In perpetual contracts, you must maintain your initial margin, meaning the minimum amount of capital required to open a position. And also meet the maintenance margin requirement to keep the position open.
Since positions can be held indefinitely, you must be especially mindful of margin calls. Margin calls occur when your account balance falls below the required maintenance margin due to losses. You will be required to deposit additional funds to meet the margin requirement, or your position may be liquidated to cover the losses. Being attentive to margin calls is especially important in the case of volatile cryptos, where prices can swing rapidly, triggering liquidation if the margin falls below the required level.
What Is the Funding Rate in Perpetual Contracts?
The funding rate in perpetual contracts is a periodic payment between traders holding long and short positions. Its primary goal is to balance supply and demand in the market.
If the funding rate is positive, traders with long positions pay those with short positions. This encourages more short positions to enter the market.
If it’s negative, short traders pay long traders, helping to balance the market.
This mechanism keeps the contract price close to the underlying asset’s spot price. Here’s a simplified diagram that shows how funding rates balance long and short positions:
Why Choose Perpetual Contracts?
Perpetual contracts serve the same purposes as futures — speculation, and hedging — but their flexibility makes them more attractive for specific traders.
As an investor, you might prefer a perpetual if you want to hold positions indefinitely without worrying about expiration dates. This allows you to better adapt to market conditions, especially in highly volatile cryptos, where price trends can shift unpredictably over time.
Pros
- No expiration date offers greater trading flexibility.
- Leverage allows you to amplify potential profits.
- Useful for hedging long-term cryptocurrency positions.
- Funding rates keep the contract price aligned with the spot market.
Cons
- Leverage can lead to significant losses.
- Continuous margin adjustments increase liquidation risk.
- Funding rates can add ongoing costs.
- Market volatility may cause rapid price swings and higher risk.
Crypto Options Contracts
Crypto options have been becoming popular among investors. This popularity is due to the lack of obligation to buy or sell crypto at a set price before the expiration date. In this case, you have two options to fulfill the contract:
- The call option, which allows you to buy the assets at a lower price
- The put option, where the assets are sold at a higher price
Other methods are American and European options. American options allow you to exercise the option at any time before or on the expiry date, offering more flexibility in responding to market movements. European options can only be exercised on the expiry date, limiting action but generally offering lower premiums due to this restriction.
For an options derivative to exist, these components must be agreed on:
- Premium: The price paid to enter the contract
- Strike price: The agreed price to buy or sell the crypto
- Expiry date: The date by which the contract must be settled
It’s important to highlight that in cryptocurrency options, you can choose to complete the contract but are not required to buy or sell the underlying crypto.
Like futures and perpetuals, crypto options are used for speculation and hedging. However, options offer more flexibility since they don’t require the holder to execute the contract if the market doesn’t favor them.
As an investor, you might choose options over futures or perpetuals to limit risk while profiting from market movements. Unlike futures, your losses are capped at the premium you pay for the option, providing a more controlled risk exposure.
Writing Options
Another widespread use of options contracts is “writing options.” This involves selling options to other traders, allowing you to collect the premium as a profit.
For example, when you write a call option, you agree to sell the underlying asset at the strike price. If the option expires without being exercised, you keep the premium as a profit without selling the asset.
Writing options is a way to make money with cryptocurrency in relatively stable markets. However, it also carries risks, especially if the market moves against the writer’s position.
Pros
- Limited risk to the premium paid by the buyer.
- Flexibility in choosing whether to exercise the contract.
- Can hedge against potential losses in volatile markets.
- Offers profit potential with a lower upfront investment.
- Suitable for both long and short positions.
Cons
- Complexity in pricing due to various influencing factors.
- Risk of significant loss when writing options.
- Requires active monitoring and management to avoid losses.
- Volatility can make predicting outcomes difficult.
In-the-Money (ITM) vs. Out-of-the-Money (OTM) vs. At-the-Money (ATM) Options
In options trading, ITM (In the Money) and OTM (Out of the Money) describe the relationship between the option’s strike price and the current market price. It can be applied with a call or put option.
Call Options:
- ITM Call Option: A call option is considered in the money when the market price of the underlying asset is higher than the option’s strike price. For example, the call is ITM if you have a call option with a strike price of $100 and the asset trades at $120. This happens because it gives you the right to buy the asset at $100, below the current market price.
- OTM Call Option: A call option is out of the money when the current market price is lower than the strike price. For example, if the strike price is $100 but the asset is trading at $80, the option is OTM. This means it wouldn’t make sense to exercise it, as buying at $100 is higher than the market price.
Put Options:
- ITM Put Option: A put option is in the money when the underlying asset’s market price is lower than the strike price. If you have a put option with a $100 strike price and the asset trades at $80, it’s ITM. It allows you to sell at $100, above the current market price.
- OTM Put Option: A put option is out of the money when the market price is higher than the strike price. If the strike price is $100 but the asset trades at $120, the put is OTM. We define it this way because selling at $100 when the asset is worth more in the open market isn’t financially logical.
| Option Type | In-the-Money (ITM) | Out-of-the-Money (OTM) |
|---|---|---|
| Call Option | Market price > Strike price → Profitable | Market price |
| Put Option | Market price | Market price > Strike price → Loss |
| Value | Has intrinsic value and is typically more expensive | No intrinsic value, speculative and cheaper |
Key Differences Between Futures, Perpetual, and Options Contracts
In this section, we’ll provide a comparison table to help you better understand what sets different crypto derivatives — like futures, perpetual contracts, and options — apart. It will make identifying which derivative best suits various trading strategies and goals easier.
| Futures Contracts | Perpetual Contracts | Options Contracts | |
|---|---|---|---|
| Contract Expiration | Set date | No expiration | Set date |
| Settlement | Cash or physical | Cash | Cash or physical |
| Funding Costs | None | Ongoing | None |
| Flexibility | Limited | High | High |
| Profit Potential | High with leverage | High with leverage | Capped (premium paid) |
| Ideal For | Experienced traders | Active traders | Conservative traders |
How to Start Crypto Derivatives Trading
Now that you understand how crypto derivatives like futures, perpetual, and options work, you can start trading them. Here are the steps to start trading crypto derivatives:
- Choose a Reputable Exchange: Select a trusted crypto exchange that offers derivative trading. Ensure it provides the derivative products you want to trade and has robust security measures.
- Open an Account: Sign up for an account on the exchange. Complete the KYC identity verification if required by the platform.
- Fund Your Account: Deposit funds in crypto or fiat into your exchange account. Ensure you have enough balance to trade derivatives and cover any margin requirements.
- Select Your Derivative Product: Decide whether to trade futures, perpetual contracts, or options. Choose the crypto asset you want to trade and set up the appropriate contract.
- Set Leverage and Margin: If using crypto leverage, choose the leverage ratio that fits your risk tolerance. Ensure you have sufficient margin to open and maintain positions.
- Place Your Trades: Based on your market analysis, execute a buy or sell order. Depending on your strategy, you can use market, limit, or stop orders.
- Monitor and Manage Risk: Track your positions and adjust them as needed. Use stop-loss orders and manage leverage and your margin carefully to avoid liquidation.
- Close Your Position: When ready, close your position by selling or buying back the contract. Review your profit or loss and adjust your strategy for future trades.
Next, we’ll discuss the best crypto derivatives trading platforms and risk management strategies, including leverage management, to help you limit losses while maximizing returns.
Best Crypto Derivatives Exchanges and Trading Platforms
To help you navigate the world of crypto derivatives, we’ll explore some of the best crypto exchanges and trading platforms.
Whether you’re looking for advanced features, liquidity, or user-friendly interfaces, these platforms provide various tools to trade futures, perpetuals, and options efficiently. We’ll break down the strengths and unique offerings of each to help you choose the best exchange for your trading needs.
Features of derivatives trading exchanges:
When trading crypto derivatives, it’s important to understand specific features that are unique to these exchanges. These tools help manage risk, optimize profits, and protect against extreme market conditions. Here’s a breakdown of key features:
- Stop-loss and take-profit: These automated orders allow you to set predefined levels for exiting a position. Stop-loss minimizes losses by selling when the price drops to a certain level, while take-profit secures gains by selling when the price reaches a target.
- Partial close orders: This feature allows you to close a portion of their position while leaving the rest open. It helps lock in some profits or limit risk without entirely exiting the trade, providing more flexibility in volatile markets.
- Auto deleveraging (ADL): It protects the exchange during extreme volatility. If a highly leveraged position cannot be liquidated at a safe price, ADL automatically reduces your leverage on the opposite side. This happens to prevent the platform from losing funds.
- Insurance funds: These funds act as a safety net for exchanges to cover losses when positions are liquidated at a price worse than the bankruptcy price. The insurance fund helps avoid socializing losses among traders, offering more security in case of extreme market events.
Best Crypto Futures Exchange: Kraken
is one of the most reputable cryptocurrency exchanges. Established in 2011, it is known for its wide range of supported assets, robust security features, and substantial regulatory compliance.
It caters to beginners and advanced traders, offering a user-friendly interface and advanced tools for professional traders. With its secure infrastructure and global reach, Kraken has become a go-to platform for cryptocurrency trading and investing.
Kraken is one of the best exchanges for trading futures and perpetuals. It offers various features designed explicitly for derivative traders, such as low fees, up to 50x leverage, and deep liquidity across major crypto assets like Bitcoin and Ethereum.
Kraken’s futures platform is designed for seamless navigation, with advanced charting tools and risk management features like stop loss and take-profit orders, allowing you to manage positions effectively in volatile markets.
Kraken also provides 24/7 support, a great insurance fund to protect against liquidation losses, and the Auto Deleveraging (ADL) system to manage risks during high volatility. These features, combined with its broad futures offerings and a commitment to security, make Kraken one of the best platforms for trading crypto futures and perpetuals.
Best Exchange to Trade Crypto Options: MEXC
is a globally recognized cryptocurrency exchange known for its wide range of supported assets, user-friendly interface, and robust security measures.
Launched in 2018, it quickly gained popularity due to its competitive fees, large trading volumes, and accessibility across numerous regions. The platform supports spot, margin, and derivative trading, making it a versatile choice for new and experienced traders.
MEXC is an excellent exchange for trading options due to its advanced features tailored specifically for options traders. One standout feature is its intuitive interface, which simplifies complex options and strategies, allowing you to navigate between calls and puts quickly.
MEXC also offers a variety of crypto options, including European and American options, giving you the flexibility to choose based on your trading strategies. Additionally, MEXC provides real-time data, advanced charting tools, and leverage options, allowing for more strategic decision-making when executing options trades.
What makes MEXC even more appealing is its low fees and extensive educational resources, which help you better understand the intricacies of options trading. Its risk management tools, such as stop-loss orders and 24/7 customer support, ensure you can trade confidently, making it one of the best platforms for trading crypto options.
Crypto Derivatives Risk Management
Due to the high volatility and leverage involved in crypto derivatives, managing risk is crucial. You should employ risk management strategies to protect capital while maximizing potential returns.
Position sizing is essential. Allocate only a small portion of your capital (e.g., 1-2%) to each trade, especially when using high leverage. This reduces the risk of catastrophic losses if the market moves unfavorably.
Leverage management is critical in futures and perpetual contracts. Over-leveraging can quickly lead to liquidation. Start with low leverage and gradually increase as your market understanding improves. Avoid high leverage unless you have a solid strategy and high-risk tolerance.
Stop-loss and take-profit orders are vital tools to automate risk management. A stop-loss limits potential losses by exiting a position at a predetermined price. Take-profit orders secure gains before the market reverses and can help lock in profits as the market moves in your favor.
Hedging can mitigate risk. You can use futures or options to hedge your crypto portfolio by offsetting potential losses in your spot holdings. For example, buying put options can protect against a fall in the value of a cryptocurrency.
Lastly, it’s essential to stay aware of market conditions and volatility. When volatility increases, adjust position sizes and exposure to avoid excessive risk.
Final Thoughts on Crypto Derivatives
Crypto derivatives have grown significantly, offering various tools to speculate and hedge against price volatility. These instruments, from futures contracts to options and perpetual contracts, provide both opportunities and risks.
While the potential for high profits exists, it’s crucial to have a firm grasp of risk management strategies, especially when dealing with leveraged trades and highly volatile assets. Without proper knowledge and safeguards, the chances of incurring significant losses increase.
Watch our exclusive interview with Greg Magadini, Director of Derivatives at Amberdata, to deepen your understanding of how crypto derivatives work and how to use them effectively. Greg offers valuable insights on navigating the crypto derivatives market, managing risks, and maximizing opportunities.
FAQs
Are crypto derivatives profitable?
Yes, crypto derivatives can be profitable, but they carry high risks. You can use them to speculate on price movements or hedge existing positions. Profitability depends on skill, strategy, and proper risk management, as high leverage can amplify gains and losses.
Can you trade crypto derivatives in the US?
Yes, you can trade crypto derivatives in the US, but it is limited to regulated platforms like CME and LedgerX. Retail platforms like Binance and FTX restrict US users due to regulatory constraints imposed by the CFTC.
Which crypto exchange is best for derivatives?
is the best crypto exchange for derivatives, offering up to 50x leverage, deep liquidity, and a wide range of futures and perpetual contracts. With low fees, advanced risk management tools, and robust security, it’s ideal for new and experienced traders looking for a reliable platform to trade derivatives.
What is the largest crypto derivatives exchange?
is the biggest crypto derivatives exchange, boasting over 370 coins and 1,247 trading pairs globally and handling over $12.8 billion in Reported Trading Volume, according to CoinGecko. Its extensive offerings include futures, perpetual contracts, and up to 125x leverage options, making it the top choice for high-volume traders.
References
- Binance (CoinGecko)
- Crypto Derivatives Market Size 2023 (CoinGecko)
in numbers
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