Investments in the global financial market have enough diversification and sophistication to match the various needs of investors. To a newbie in the investment scene, terms like “derivative contracts,” “futures,” and “swaps” may sound complicated and multifaceted. This is because they sound fancy yet describe pretty simple concepts in asset management and trading.
So, What Exactly Is A Financial Derivative Contract?
The word “derivative” literally means “something that is a product or extract of something else.”
A contract is an agreement between two or more parties about a certain commercial interest.
A derivative contract is, then, an agreement about an underlying asset – a digital asset, stock, bond, etc. – that is traded on the market as a unique product but whose value is contingent on the performance of that asset.
Derivatives are a common element in modern investment circle, and it is highly recommended that experienced traders dabble in these products. Nonetheless, despite the prerequisites and limiting regulations in certain jurisdictions, many cryptocurrency exchanges are increasingly offering these products.
For the role they play, derivatives are an integral part of the global market, as they help maintain equilibrium. In the crypto scene, derivative contracts are mostly linked to other digital assets, like Bitcoin, XRP, Ethereum (ETH), GRAM, and even ADA, provided they are liquid.
In the traditional markets, investors can trade in derivatives on publicly regulated exchanges. Within the crypto scene, most derivatives are traded through centralized cryptocurrency exchanges. However, crypto derivative contracts are also available in regulated public exchanges like the CME, which can only be accessed through a broker.
Overly, there are two broad classes of derivatives: lock-like Futures and forwards, which are binding, and options, such as swaps, which are partially non-binding. Both can be used for hedging, mitigation efforts, or rewards through speculation, which can either bring stability or cause devastation.
Below is a table comparing the trading volumes of different cryptocurrency exchanges:
|Exchange||Type||Daily Trading Volumes|
|OkEx||Spot and Derivative||$847,628,890 (Perpetuals)
|CME||Derivative||$90,092,749 (Expires in 2019)|
|Xena Exchange||Spot and Derivative||$1,455,706 (Perpetuals)|
The History of Derivative Contracts
Unbeknownst to many, derivative contracts have actually been around since ancient times. Naturally, there has been tremendous evolution in their maturity over the centuries, just like most aspects of commerce. The history of financial derivatives spans millennia. Merchants in early civilizations like Babylon would draw up risk-sharing agreement to access loans for their caravans. They would repay these loans if the goods successfully made it to their destination and were sold in distant markets. Accordingly, the loans they took had value based on the goods they shipped to these markets. In more direct terms, the funds “derived” their value from the goods in transit.
Such contracts were also present in other groups, especially traders and explorers. The Spanish, who explored much of North and South America, often get credit for propagating the concept westwards. They would often set sail on derivative funds with the promise of plunder and booty from the conquered lands. In relatively modern times, derivative contracts first appeared on the London Stock Exchange in the 1830s and entered into practice in the United States in the 1850s.
Nowadays, derivative contracts are a mainstay in the markets. This even extends to cryptocurrency, where traders can acquire derivatives in the form of products like Bitcoin futures. The most common platforms where investors can channel their money and invest in derivative contracts are the Chicago Mercantile Exchange (CME Group), the Chicago Board Options Exchange (CBOE), and a number of cryptocurrency exchanges, especially BitMex, BitFinex, and OKCoin.
You can trade derivative products in the following exchanges:
|Exchange Name||Bitcoin Product||Daily Trading Volumes||Leverage|
|CME||Futures||$90,092,749 (Expires in 2019)||3.33x|
|BitMex||Perpetuals and Futures||$5,960,476,439 (Perpetuals)
|Up to 100x|
|OKEX||Perpetuals and Futures||$847,628,890 (Perpetuals)
|Up to 100x|
|Deribit||Perpetuals, Futures, and Options||$548,187,447 (Perpetuals)||Up to 100x|
|Xena Exchange||Perpetuals, Futures (to be added soon)||$1,455,706||Up to 20x|
|Prime XBT||Perpetuals||$277,591,867||Up to 100x|
|Bybit||Perpetuals||$1,310,546,664||Up to 100x|
Types of Derivative Financial Instruments
Needless to say, in the financial market, there are tons of financial derivative types. Examples of derivative contracts are as follows:
- Forwards: In a forward contract, two or more parties enter into an agreement with the obligation to either buy or sell an asset at a future point in time at the price agreed upon today. The party that agrees to buy the underlying asset is entering a long position, and the one that agrees to sell is entering a short position. The price on which both parties agree to settle is called the delivery price. Often, this type of derivative contract is traded at over-the-counter (OTC) exchanges and is usually non-standardized.
- Options: An options contract is a derivative instrument that gives the buyer or the holder the right but not the obligation to either buy or sell the underlying asset at a preset price within a given period of time. The right to buy is the call option, and the right to sell is called the put option. Furthermore, when the options contract lacks special features or terms, it is called vanilla. If it is laden with special structures, terms, and conditions, then it is called exotic. Overly, an options contract offers the holder versatility and is often used to hedge or speculate on underlying asset prices.
- Futures: A futures contract is a standardized and a binding legal agreement traded on exchanges where the buyer is obliged to either buy or sell an asset in the future at the predetermined price agreed upon today. Once the time period has expired, the buyer of a futures contract is required to buy the underlying asset. On the flip side, the seller is required to sell the underlying asset. Often, futures are traded in cryptocurrency exchanges in standardized forms to hedge against risks. Upon expiration of the contract, the difference in price is settled in cash.
- Swaps (based on interest rates): A swap contract is a derivative product where the involved parties can exchange cash flows of the underlying asset each holds based on the prevailing interest rates. Usually, the principal amount is fixed, and in the case of interest rate swaps, the cash flow of one party is usually fixed, while that of the counterparty varies based on floating FX rates, the index price, or even the benchmark interest rate. A typical swap specifies the date when the cash flows will be paid and the way these cash flows are calculated. Usually, swaps afford investors the ability to exchange the benefits of their securities. For example, if the swap in question involves two bonds, the user can draw benefits from coupon payments.
Benefits of Derivatives for Traders
In the investment landscape, derivatives can offer certain advantages that make a lot of sense because the following factors make investing and business more efficient:
- Leverage Returns
When trading derivatives, investors usually have the ability to make high returns because of the possibility to trade with leverage. This is not necessarily the case for primary investment vehicles such as cryptocurrencies, stocks, and bonds, which are not usually leveraged. When using leverage, traders can borrow less, often at around x3. Leverage for derivatives is usually much higher, ranging from x5 to x100 on popular exchanges. For example, an unleveraged BTC investment could take months to double or triple the principal amount. In derivative trading, a savvy trader can make the same in a week because of high leverage and partly because of the ability to trade in both directions.
- Non-Binding Contracts
The advantage of certain derivative products, such as options, is that the holder has the right but not the obligation to exercise the terms of the deal. However, note that the seller of the option must execute the terms as per the initial agreement should the holder decide to exercise his or her option. It therefore goes without saying that the flexibility varies based on the derivative instrument you hold because certain derivatives, like swaps or futures agreements, are actually legally binding. Nonetheless, you still generally have wide flexibility in your investment strategy.
- Advanced Investment Strategy
Incidentally, there is an entire discipline called Financial Engineering that mostly focuses on derivatives. Investors can create very sophisticated investment strategies using derivatives. This is not to say that beginner investors are totally out of place: Rather, it’s the case that once you become really great at understanding derivatives, you can make sleek moves in the market.
These are solid reasons to trade with financial derivatives. However, there are some things that you need to know before entering this market. Financial derivatives can be as risky for an investor as they are lucrative, especially when an investor goes fully in without doing any prior research or assessment of the instruments.
Downsides of Cryptocurrency Derivatives
- Volatility - The open-market trading of digital assets means that the prices of derivatives can change dramatically.
- Lack of standards - Given the fragmentation and disparate regulation in the crypto landscape, it is not surprising to find the same contract on different cryptocurrency exchanges settling in different currencies based on different underlying indexes.
Learn the Ropes
In general, investing in derivatives calls for a thorough understanding of how they actually work. As a matter of fact, a decent understanding of derivatives can protect you from potential scams in the market. In a market this lucrative, there are tons of nefarious actors looking to prey on the financial derivative ignorance of others to make a killing. The largest Ponzi scheme, by the infamous Bernie Madoff, actually relied on derivatives scams.
This means that the derivative market is not one to just jump into the deep end. Professional money managers, financial engineers, and highly experienced investors largely make up the derivative trading scene.
However, this is not to say that newbies can’t dabble in derivatives to test the waters. Rather, we are simply acknowledging that this market can have pitfalls and that one needs to be savvy with the types of contracts and investment strategies before factoring them in one’s investment portfolio. Moreover, the volatility of financial derivatives means that you shouldn’t put all your eggs in one basket because of the larger financial risk of dealing with more volatile products. Therefore, they should only make up a certain amount of your investment portfolio.
Trading Cryptocurrency Derivative Contracts
Annually, investors trade tens of billions of financial derivative contracts in financial markets across the world. According to the Bank for International Settlements (BIS), the notional value of all outstanding contracts in the global financial market exceeded $514 trillion in 2018.
A huge market valuation, right? Now let’s see where derivatives come into play. A trader enters into a futures derivative contract that promises delivery assets at an agreed price. Thus, the selling firm will be safe even in the scenario of a price rise. Such contracts to protect traders or investors against future uncertainties in the market are commonplace in modern commerce.
Even though most of the world’s derivative trading is via marquee investors, exchanges play a minor role in this field. A large exchange like CME, a merger of the Chicago Board of Trade and the Chicago Mercantile Exchange, offers all kinds of derivative classes, including Bitcoin futures.
Financial Derivative Risk Management
Derivatives definitely come with a certain level of risk. That said, it is possible to speculate and take advantage of the price variation of underlying assets favorably, since financial derivatives are broad and varying. All the same, it is possible to manage and mitigate the risk that the derivative itself brings.
A shrewd investor can make a decent return if they enter a derivative with a purchase price lower than what the asset price will be at the end of a futures contract. It goes without saying that this is not always a cakewalk, meaning that the importance of understanding the derivative’s underlying asset is invaluable.
To manage risks, investors can make use of available risk management measures, such as stop-loss or trailing-stop orders, to protect their portfolio against value erosion. In the ideal case, the investor would earn money if the price of the underlying – which can be Bitcoin, ETH, a volatility index, a mining complexity index, or even GRAM – edges higher. On the contrary, if prices tank, then the applied risk management measure would be a shield against huge losses.
For traders, perpetual contracts with leverage backed with smart liquidation can be an avenue for capitalizing on market swings. To avert losses, special orders such as stop-loss, take-profit orders, attempt zero loss orders, and trailing stop loss orders – managed on the server side on Xena Exchange – allow for automation and can be used to your advantage if you strategize well and get the timing right.
Derivatives Trading with Xena Exchange
You don’t master the art of trading overnight, even if that entails learning derivative trading basics. This is why it’s important to check out reliable sources when handling and smoothing out your financial derivative learning curve.
Xena Exchange offers traders a repertoire of instruments to make trading more convenient, lucrative, and diverse. The exchange has a live derivative contract trading engine, with Bitcoin (XBTUSD) perpetual contracts as the first derivative. The contracts on Xena Exchange mirror the price of the underlying asset, be it BTC, GRAM, or an index, such as BTC volatility, and are subject to regular hourly clearings.
Xena Listed Perpetuals have the following advantages:
- They do not expire, which gives them an advantage over futures.
- They can be traded with up to 20x leverage.
- Trading perpetuals involves safe liquidation and mechanisms to protect against manipulation.
Additionally, the available order types present an excellent platform to suit a variety of needs and tastes that fit the strategies of traders.
With perpetual contracts that offer up to 20x leverage, the ceiling on profitability is high (but so is that for the risk) and is made better by the counterparty-risk-slashing benefits of decentralized accounts (dAccs). In addition, traders have the option to go long or short, depending on the prognosis eased by useful proprietary indicators such as trend power and tools such as the Xena Market Barometer.