What is a Derivative?
Have you heard of Bitcoin Futures? Christina Czeschik, the author of this article, is also publishing a book on cryptocurrencies for beginners that will help you get started nice and easy: Cryptocurrencies for Fun and Profit with Ratko Stambolija. Bitcoin and other cryptocurrencies have evolved from a playful experiment among technical experts to an established and growing branch of the global financial industry.
This means that the times in which cryptocurrency traders and investors only concerned themselves with straightforward buying and selling are over. Derivatives are now entering the picture.
Think of a derivative as a bet between two parties about the development of an underlying asset. These instruments are derived from the value of the underlying asset, having no value of their own.
In traditional financial markets, derivatives are used as speculation objects as well as insurance against losses. The latter is known as hedging. One popular variety of derivatives used for hedging are called futures.
A future is a contract between two parties in which one party agrees to pay the other a predetermined amount of money for an underlying asset at a specific point in time. Trader A is a producer of pork bellies. In order to insure herself against a price drop in pork bellies in the future, she enters a futures contract with Trader B. Trader B uses these pork bellies to manufacture sliced breakfast bacon. Thus, he is not worried that prices might fall in the future — his worry is that prices will go up.
Both traders agree that Trader A will sell a metric ton of pork bellies for 1, USD 3 months from now. This increases security for both of their businesses.
Because a futures contract is a binding contract between two parties, neither party can drop out of the contract: Even if the price for pork bellies is 1, USD at the time of execution, trader A is still contractually obliged to sell for 1, USD.
Traders A and B in the previous example are hedgers. However, futures contracts, once they exist, can also be bought and sold in their own right.
This is where futures get interesting for speculators. He can then sell the contract to bacon producers who want to buy pork bellies at 1, USD. The option to buy at a specified price in the future is known as a call option. The price of call options rise when traders assume that the price of the underlying asset will rise. For her, having the option of selling pork bellies for USD in the future is highly attractive.
Such options to sell are known as put options. The price of put options rise when traders expect the prices to fall of an underlying asset. That means that with a limited amount of capital, you can profit much more by buying options than assets — but also lose much more. This is because a small difference in the price of the underlying asset immediately leads to a substantial change in the price of the derivative. These numbers are just approximate examples. The exact price of an option depends on the following factors:.
As for why you should buy a put option instead of the asset itself, the answer is simple. By buying the asset itself, you can never profit from falling prices. With put options you can, simply because their value rises as the price of the underlying stock is falling. In addition to this feature, they offer the same kind of potential for leverage that calls options do, as described above. The price of put options is calculated in a similar manner, but with the important difference being that the intrinsic value is calculated as a predetermined price of the option minus the current market price of the asset — not the other way round as is the case for call options.
It is important to note, however, that leverage means that your potential losses may also be much higher. If pork belly prices fall, call options lose value in a much higher proportion than the pork bellies themselves. A Bitcoin futures contract is exactly what you would expect from the example above, replacing pork bellies with Bitcoin. It is a contract that enables you to buy Bitcoin at a predetermined price at a specific point in the future.
Just like cryptocurrencies themselves, crypto derivatives have been adopted enthusiastically by the crypto community, and have been traded in an unregulated manner at first, and have even been used as a way to avoid the increasingly heavy regulation in the traditional financial sector.
And just like cryptocurrencies, they soon saw the first backlash from governments and authorities — take for example the Chinese cryptocurrency ban. Crypto derivatives were naturally discovered as an interesting addition to cryptocurrency exchanges first — probably as individual contracts between interested investors on these exchanges.
The most common way to trade in Bitcoin and other cryptocurrency derivatives today is through contract-for-difference CFD contracts. These CFD contracts are usually traded over the counter OTC , meaning that they are not traded on exchanges but directly between participants.
Due to the high volatility exceeding 1. So far, these derivatives market have only been a niche occupied by crypto enthusiasts. That is until one of the newcomers, Crypto Facilities, and an incumbent in the derivatives market have joined forces: Crypto Facilities and the CME Group. The CME Group controlling, for example, the Chicago Mercantile Exchange that has been around for more than a century is a large-scale business that is officially regulated and audited by the US financial authorities.
It settles its contracts in fiat money rather than cryptocurrency, thus enabling non-crypto experts to speculate on Bitcoin. Such an official rate is a prerequisite of options trading in the traditional markets.
More concretely, it is calculated based on all Bitcoin vs. USD trades on the participating exchanges between 3 and 4 p. London time. To calculate the BRR, the hour between 3 and 4 is divided into 12 intervals of 5 minutes. For each interval, the volume-weighted median of the Bitcoin price is calculated statistically, the median, in contrast to the average, prevents single outliers from distorting the price.
The BRR is then the average of these 12 median values. Taken together, they control the largest derivative market in the world. London time only.
Both can be monitored on the Crypto Facilities website. As we have seen above, a futures contract has an expiration date. This is the date on which you can purchase the ton of pork bellies for 1, USD — this is called a physical settlement. Alternatively, futures contracts can be settled with cash as well. In these contracts, you receive the difference between the current price of the underlying asset and the price in your contract as cash. And this is where the BRR comes in. The BRR is the reference rate that is relevant for futures contracts and options in Bitcoin.
When a futures contract or call option expires on a certain day, the owner will receive the difference between the BRR and the Bitcoin price in the contract as cash if the BRR is higher than the price in the contract, of course. The BRTI, in contrast, is a real-time statistic that is not binding for any contracts; it tells you for what price you can currently in this second buy or sell Bitcoin on the markets. The CME Bitcoin futures contracts will be cash-settled , meaning that you will receive USD on the expiration date if your speculation was successful and you have not sold the derivative before the expiration date.
You will not receive Bitcoin — that would be a physical settlement, even though Bitcoin is not a physical asset. This is a crucial difference because it enables traders to trade in Bitcoin futures without having a cryptocurrency wallet. Every transaction is done in USD. Thus, it is easy for mainstream traders to take part in this market. See here for more details about the futures contracts at CME.
As described above, you can assume one of two positions in regards to trading in futures and other derivatives: Long and short. When you follow a long strategy, you speculate on prices of the underlying asset going up. With a short strategy, you speculate on prices going down.
And if you expect Bitcoin prices to go up, you are interested in buying call options — options that enable you to buy Bitcoin at a predetermined price in the future. For example, if the current Bitcoin price is 5, USD and you expect it to rise to 8, USD 6 months from now, you would certainly pay good money for a call option that allows you to purchase Bitcoin for USD in 6 months, when everyone else is buying for 8, USD. Buying put options will enable you to sell Bitcoin at some point in the future at a price that is higher than the future price you expect.
In analogy to the example above, if the current Bitcoin price is 5, USD and you expect it to fall to 2, USD in 6 months, then put options allowing you to sell Bitcoin for 5, USD in 5 months when everyone else is selling for USD are very valuable.
In both of these examples, the options call option in the first example, put option in the second have an intrinsic value of 3, USD.
Going long is fairly straightforward. It is similar to buying the underlying asset itself, with the only difference being that it enables you to have more leverage. Both call and put options have, as we have learned above, a certain expiration date. For example, my call option Bitcoin for 5, USD that I am buying on November 24, , may have a running time of 6 months and thus expire on May 24, I can sell this option at any time between now and May 24, Then my option is very valuable because it enables me to purchase Bitcoin significantly cheaper than the current market price.
However, if the price of the underlying asset is going down, your options usually become worthless before the expiration date. Everything discussed above is true for put options as well, except that their value development goes in the opposite direction.
They become more valuable as the underlying asset price is falling. A futures contract, as we have mentioned above, is a contract between two parties who agree to make a transaction of an underlying asset at a specified time in the future. You enter into this contract on an exchange like CME. Now, what if the Bitcoin price is rising? In order to still make things fair for both participants, the exchange here CME will make sure that you can sell for the current market price of 5, USD if you so wish, but they will compensate your contract partner for this.
They will take the difference — USD — out of your so-called margin account and give it to Mortimer. This kind of settlement is not only performed on the fulfilment date of the futures contract, but on every trading day, according to the current price of the asset. In order to make sure that you actually have money in your margin account to settle the difference with Mortimer every day, you are required to put up an initial margin at the beginning of the contract. A lower sum, the so-called minimum margin or maintenance margin , is also defined by the broker.
How Does Settlement Work for Bitcoin Perpetuals?
Crypto-asset derivatives have evolved rapidly since the introduction of bitcoin futures on the Chicago Mercantile Exchange CME inand has provided traders and crypto enthusiasts with exciting new opportunities and exposure to the burgeoning asset class. Traditional derivatives, such as options and when wil bitcoin derivatives start trading, are settled at particular time periods. Futures contracts are only settled at the end of a set time period, but the price is agreed upon at the time of entry. A trader can buy or sell these futures contracts, depending on which way they think the price will go by the end of November. Once a trader enters a bitcoin futures position, the profits or losses are not realized until the contract expires.
How Does Settlement Work for Bitcoin Perpetuals?
On this page you can find all the Bitcoin Exchanges and Trading Platforms which allow derivatives trading. All those active in the trading world have probably heard about derivatives trading. Below we are going to explain what is a derivative, how does derivatives trading work and what are the risks associated with it. The derivative is a term used for anything — a contract, security — that gets its value from its relation to another asset such as bonds and stocks. Traders usually get into the derivatives trading because it gives owner more freedom than the stock or bond. Derivatives contracts are usually non-binding, offer the possibility to get high leverage returns, and financial gurus love them because they allow the use of advanced trading strategies. There are thousands of different kinds of derivatives, but the majority of the trading revolves around the key three:. Options are contracts made between two parties to purchase or sell an asset at a given price. This the most common type of derivatives. Swaps give traders the opportunity to trade the benefits of their securities between them.
Trade Bitcoin Derivatives:
Crypto-asset derivatives have evolved rapidly since the introduction of bitcoin futures on the Chicago Mercantile Exchange CME inand has provided traders and crypto enthusiasts with exciting new opportunities and exposure to the burgeoning asset class.
Traditional derivatives, such as options derivtaives futures, are settled at particular time periods.
Futures contracts are only settled at the end of a set time period, but the price is agreed upon star the time of entry. A bitcokn can buy or sell these futures contracts, depending on which qil they think the price will go by the end of November. Once a trader enters a bitcoin futures position, the profits or losses are not realized until the contract expires. Traders can also use futures to protect themselves from any price fluctuations.
For instance, they can enter a short position with a futures contract and a long position in the spot market. But as the expiry of the futures contract wben, the trader could sell bitcoins in the spot market triggering a sharp fall in the price and cause the value of the short futures position to rise, netting the trader a higher profit. Their research illustrated that the price of bitcoin falls on average 2. The bitcoin perpetual swap appeared on the market a few years ago and provides a very simple and innovative instrument for traders.
Perpetual contracts are like futures, but they never expire, giving the trader more control over their positions. To keep the price of the contract in line with the price of bitcoin, funding payments are used to incentivize long or short positions, depending on whether the perpetual is trading at a discount or at a premium to the spot price.
Most cryptocurrency derivatives incur the funding payment at fixed intervals, typically every eight hours. While perpetual contracts get around the settlement issues associated with futures i.
In addition, perpetuals with funding payments introduce market distortions similar to futures contracts, as evidenced by the unnatural behavior displayed leading up to the funding payment period of perpetuals. As the funding payment interval approaches, certain traders might close their positions to avoid paying the interest rate, leading to a lot of abnormal market activity.
Alternatively, if the funding rate is high tradung settlement approaches, traders who are highly leveraged may not meet their maintenance margin after the funding fee is paid and are liquidated from their position. If enough traders are liquidated around the time funding payments are due, this can trigger a chain reaction and cause the market price to crash. Profits from these types of perpetual contracts are not immediately available. Even if you are in profit, you cannot withdraw this amount or use it to open a new position until the current position is closed.
Another restriction of most perpetuals on the market is the uncertainty of the interest rate at settlement. While most bitcoin perpetual contracts use funding payments to keep the price in line with the spot price, continuous settlement provides instant payments of interest, replacing cumbersome periodic funding payments. These types of perpetual contracts are settled continuously instead of at the end of a set time period or at intervals. There are two advantages that perpetuals with continuous settlement provide as compared to those with funding rates or futures contracts :.
As an example of how continuous settlement affects a trade, suppose you use 1 BTC as collateral to trade 10 BTC worth of perpetual contracts.
If the price of tradint moves in your favor, then your profit will be available immediately to withdraw or to fund another position. You only have to ensure that you keep enough in your trading account to cover the maintenance margin. Continuous settlement also facilitates the use of more flexible trading strategies. For instance, suppose an individual takes two equal positions of 0. If they have one losing position and one winning position, the trader risks being liquidated on the losing position even though they are in profit in the.
Continuous settlement is just one of the many innovations that has surfaced in cryptocurrency trading. The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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How Does Settlement Work for Bitcoin Futures?