Bitcoin Derivatives – What are They and How Do They Work?
Bitcoin has had a history of volatility since its inception in 2009, but things are starting to change in the cryptocurrency world, and most people would say these changes are for the better. There are obvious reasons as to why having Bitcoin become a stable cryptocurrency is a good thing. Most importantly, it is necessary for any currency to be stable, if it is ever to be taken seriously as a monetary option for the masses. Nobody wants their weekly wage to be paid in a currency that can fluctuate wildly from day to day, after all. But for some people out there, the recent signs of stability within the Bitcoin world is not exactly music to their ears…
Those people are spot traders, looking to invest by specifically leveraging the volatility within many cryptocurrencies. Far from simply throwing in the towel and looking elsewhere to trade, many are looking into Bitcoin derivatives and their potential instead, trading on contracts for difference (CFDs).
The four types of derivatives
In as simple terms as possible, in the financial world, a derivative is a contract between multiple parties that is based on the future price of an underlying asset. They are not a new phenomenon either, and date back to medieval times where trades among merchant that bought and sold produce across Europe in markets often used derivatives to facilitate deals.
When it comes to Bitcoin derivatives, there are a few major types to consider. Forwards and futures, options, CFDs, and swaps. While forwards and futures are similar in nature, it is worth familiarizing yourself with the differences between the four, if you are looking to invest in any form of Bitcoin derivative in the near future.
Forwards and futures, as mentioned before, are similar in nature. Futures centre around the idea that the buyer is obligated to buy the asset at a price set earlier, on a specific date in the future, and are traded on exchanges. Forwards are usually traded OTC (over the counter) and come with a counterparty risk (should either party be unable or unwilling to settle, at the prescribed time). With futures, on the other hand, the exchange clearing house acts as the counterparty itself, which drastically reduces the risk associated with this sort of trade.
Swaps are derivative contracts that exchange different types of cash flow between parties. Classic examples would be those related to interest rates, currencies and commodities. Options, on the other hand, give buyers the right to sell or purchase the underlying asset for a set price. This doesn’t, however, mean that the buyer is forced to buy the asset (depending on the specific contract).
A contract for difference (CFD) is a popular form of derivative trading. It offers an investor a cost-efficient way to trade shares, indices, commodities, foreign exchange, and treasuries. investors who believe the product will increase in value, they can buy a number of units (go long), or if they think the product will decrease in value, they can sell a number of units ( go short). With each product having a buy price and sell price (the difference between them is called the ‘spread’), investors make money depending on the price at which they enter and exit the trade. The more the market moves in the investor’s chosen direction, the more profit they make.
Reduce risk, but benefit from volatility
In the cryptocurrency world, trading in derivatives only came into being during December of 2017, in what was a hugely important move in the crypto scene. This allowed investors to reduce risk and hedge positions, something that in the volatile crypto industry is an extremely valuable ability to have. While there is obviously still risk involved, trading in derivatives does nullify some of them, while also allowing an investor to benefit from large changes in the price of their asset.
This is all pretty exciting news to crypto investors, but there is one slight word of caution to adhere to when trading Bitcoin derivatives. Keeping abreast of local regulations is something that all investors should adhere to, and trading in derivatives is no different. Laws change, country by country, so it is worth keeping an eye on how crypto in general is being regulated in your country. Many places around the world have yet to decide on how to regulate the crypto industry, and as such, keeping an ear to the ground in regard to the legalities is always a sensible practice.