How can we make profits even in market selloffs? Trading derivatives is a popular option for traders to do so. However, it is a double-edged sword that might bring us tons of benefits while having negative effects on others who lose.
What are Crypto Derivatives?
Derivatives are financial contracts between two or more entities that has its value based on the performance of an underlying asset. The underlying assets can be anything that has value. However, a derivative can have no value since it derives from the value of another asset. There are a few types of underlying assets, as follows:
- Asset and Commodity: Gold, silver, wood, rice, coffee, wheat, etc.
- Index: Bond, security, interest rate, etc.
- Fiat money: USD, AUD, EUR, etc.
- Crypto & token: Bitcoin, ETH, BNB, USDT, USDC, etc.
Investors use derivatives as financial instruments to hedge against price movements or double down their trades with leverages. In addition, they can buy and sell derivatives without borders around the world. This makes the derivatives market estimated to be worth tens of trillions of dollars in 2025.
Keep in mind that we do not actually hold the assets when trading derivatives. We open positions by creating contracts with other parties such as other traders, dealers, or exchanges.
Crypto derivatives are contracts that derive their value from the price of underlying cryptocurrencies or tokens. Crypto traders often buy and sell the contracts to make short-term profits from the price movements, which can be up or down. Trading derivatives is often used as a hop-in and out strategy.
Two big differences between crypto derivatives and traditional derivatives:
- The crypto market runs 24/7, while traditional markets only open Monday to Friday.
- Crypto derivatives are contracts that derive the price from cryptos/tokens.
As shown in the chart, monthly derivatives trading volume is bigger than that of spot volume on average. In fact, derivatives traders often open and close their positions in short periods of time while spot investors hold their positions. Therefore, derivatives traders contribute lots of liquidity to the overall crypto market.
Types of Crypto Derivatives
Futures are contracts that traders buy and sell at a predetermined price in the future. They can trade on exchanges where buyers and sellers meet together in a high-volume market. In traditional finance, futures are tradable on authorized exchanges like Chicago Mercantile Exchange (CME/United States), Montreal Exchange (MX/Canada), Japan Exchange Group (JPX/Japan), and so on.
In crypto, there are also centralized and decentralized derivatives exchanges like Binance Futures, FTX, dYdX, Perpetual, etc. Those exchanges enable crypto-traders with up to 100x leverages, depending on the type of crypto assets.
Perpetual futures (or simply perpetuals) are popularly exercised on mentioned derivatives exchanges. This type of futures has no expiration date, allowing traders to close their positions at any time. In addition, the position will be liquidated if the collateral of the position is not enough to cover the loss.
Options are contracts in which participants agree to transact the asset at a determined price within a specified period of time in the future. During that time, they are able to buy or sell the asset without any obligation.
- American-style options: The right to buy and sell options within a period of time.
- European-style options: Only buy and sell options on a determined expiration date.
In crypto, there are also options markets that allow traders to buy and sell by interacting with smart contracts via web3 wallets. Traders might use crypto options for speculating the price movements to make profits.
Compared to futures, options have lower risks. Options traders only have to lose their initial investment instead of getting forced to sell when trading futures.
Synthetic assets are tokenized derivatives that closely follow the value of real-life assets. They can be tokenized stocks or tokenized commodities. This gives traders access to buy and sell those tokenized assets at any where via blockchain-based exchanges.
Data on blockchains can be transparent and trackable. In addition, users can remain anonymous while trading synthetic assets. Tokenized assets are one of the DeFi solutions that are easy to notice and have direct advantages over traditional investment instruments.
In addition, investors can permissonlessly tokenize everything by choosing an asset to tie to the token and introducing other traders to buy and sell it. Traders around the world can participate in trading synthetic assets like a stock index instead of registering KYC-ed accounts. They leverage the use of blockchain technology into the notion of synthetic assets.
Keywords explained in Crypto Derivatives
Unlike simply buying cryptos in spot trading and hold, trading derivatives allows users to be in bi-directional positions (buy and sell). The goal of trading derivatives is to make as many profits as possible. For newcomers, there might be some notable keywords in the derivatives market.
Leverage is an activity of borrowing capital to trade financial assets such as crypto futures or other types of derivatives. This means traders will have more buying and selling power than they actually have. It makes capital multiplied by a representative ratio which can be 2x, 5x, 10x, and 100x, depending on the purpose of the users.
For example, with a 20x leverage, a trader with a $100 fund can open a buying or selling position which is worth $2000. His $100 fund is the collateral to borrow $1900 from the market marker. Using leverage requires users to borrow capital, and they have to pay interest for it. Let’s dive into what fees derivatives traders have to pay.
Every exchange provides trading platforms, and they take a small fraction of each trade as a fee. Users who borrow capital to open leveraged positions have to pay the exchange the trading fee. Exchanges decide the amount on the basis of percentage, often a few decimal points of percentage.
Example of trading fees on Binance Futures:
- Commission fee = notional value * fee rate
- Notional value = size * trade price
- Fee rate is the number decided by Binance.
- Trade Price is the price when the position is opened or closed.
- Size (Contract) is the amount that the user wants to buy or sell.
On Binance, if users are certificated VIPs, they will get a fee discount based on the tiers. In addition, Binance supports users to pay BNB as trading fees to get fee discounts. Besides Binance, other exchanges also have different programs to incentivize and attract more users.
Fees to hold derivatives positions
For some derivatives products, users have to pay overnight fees for holding opened positions. This often happens to CFD (Contract for Difference) products by reflecting the surging buying and selling demand of the market.
Since perpetual futures have no expiration date, traders have to periodically pay fees for their long or short positions depending on the deviation of the perpetual price and the spot price. When the funding rate is positive, traders in long positions pay the fee for short positions. On the other hand, short traders pay long traders since the perpetual price is lower than the spot price.
Not all exchanges take overnight fees or fees from the funding rate. It depends on the goal and policy of each exchange. Changing the fee tier can hugely affect users’ experience. Some early-stage exchanges, often have no-fee or partially no-fee support for their users. As a result, by weight the pros and cons of the fee policies, users can choose appropriate exchanges to click the button.
In crypto, trading volume is the total value of executed trades on public markets. Investors often measure trading volume over time, such as 24 hours, 1 week, 1 month, or 1 year.
The higher the trading volume, the lower the slippage is. Traders hate price impact (slippage) when opening orders on markets. Trading volume is positively correlated to liquidity.
Trading volume also tells the amount of charged trading fees on any exchanges. As a result, there is the emergence of many big institutional-level companies joining the race to build exchanges.
Risks of trading Crypto Derivatives
Liquidation is the process in which either long or short positions are forcibly sold to reduce the risks of traders and protect the benefits of asset lenders. In other words, leveraged positions get liquidated since traders have losses outnumbering their deposits as collateral. Most liquidations happen in high-volatile markets (strong movements).
After opening a long or short position, there is a liquidating price at which the trader will be forced to sell the position. However, it will not be liquidated if he deposits enough capital to reduce the risk.
Trading derivatives with high leverage can lead to liquidation in a short period. Despite its massive return, hoping in and out of the trade can make you exhausted and fatigued to make the next decisions. Therefore, consider carefully whether high-leveraged trading is suitable for your style of trading or not.
We might spend too much time looking at the price charts and drawing technical analysis. Time is a limited resource, and we should consider it carefully before going down the rabbit hole of trading derivatives.
Over-leveraged trade can liquidate all your funds when you are off guard and take a big risk. In addition, unwelcomed consecutive losses often happen to users who trade back and forth too much.
With the same amount of time spent sitting at the trading desk, we can build other things or be patient investors who aim to hold for years.
FAQ about Crypto Derivatives trading
When does a derivatives trade get liquidated?
By using leverages in trading, users can have their trades liquidated due to major unrealized losses. To preserve stability, exchanges will liquidate their users’ trades by automated liquidation engines.
Is KYC required to trade derivatives?
Some centralized exchanges require users to do KYC to unlock additional trading features such as transfers, futures, etc. By contrast, users can opt for go-to decentralized exchanges (DEX) like dYdX, Perpetual, Synthetix, etc.
Can we make money with derivatives?
Trading derivatives means you borrow more money, adding up your capital to have bigger positions. Those positions can be liquidated if the price has any massive offset. On the other hand, trading derivatives could be profitable, which might require huge afford.
To conclude, derivatives have many forms in crypto, such as futures, options, and synthetic assets. Each type of derivatives has different rules to participation. Choosing a suitable one can give us a huge moat in the crypto market. However, there are underlying risks that should be taken into account.