Derivative

The derivative is an economic instrument that is a contract between two parties about the derivation of the value of an asset. The underlying asset determines the price. Derivative tools are used in many financial assets such as stocks, currencies, bonds, and cryptocurrencies.

In the case of cryptocurrencies, a derivative can be used as a tool for hedging and speculation.

Hedging

Hedging is a function for protecting the trader’s portfolio from a volatile market. In hedging, traders go short in the negative direction to minimize the losses from a bearish market.

Speculation

The speculation function of derivatives allows traders to profit in both increasing or decreasing value situations. In a bear market, traders can bet on decreasing prices and make a profit out of the negative situation. In contrast, the increased cost of a particular cryptocurrency will also profit the traders going long.

Popular Types of Derivatives

Let’s see 2 popular types of derivatives!

Futures contracts

Crypto futures consist of predicting the future of a particular cryptocurrency. For example, in Bitcoin, traders can decide that the value of the Bitcoin will increase in a specific amount of time. This situation is called going long, and there are different time periods depending on the trader, such as weekly or monthly. The opposite side is going short, and this side predicts that the value of Bitcoin will decrease after a certain amount of time. The exchange’s algorithm will match these two sides according to their time periods, and when the time comes, the side that predicted correctly gets paid from the side that predicted wrong.

Options contracts

Compared to the futures, the options give an “option” to the buyer not to buy the cryptocurrency when the contract ends. There are four types of options: call, put, American, and European options. Call and put options are related to purchasing or selling the cryptocurrency, respectively. While American and European options are associated with the date of the contract. For example, in the European options, the transaction of selling requires the exact agreed time compared to the American options where the selling can occur before. Traders pay fees for the contract, and if the contract expires because it is more profitable in that specific situation, the contract fee is the loss.