Derivatives in the cryptocurrency market (2)
Cryptocurrency trading and investing are still becoming increasingly popular. As more people are drawn to the young market, more financial products are becoming available to speculate on price movements. These products derive their value from an underlying asset, the spot market, and are known as derivatives. Most of these are based on Bitcoin, but we can see than an increasing number of cryptocurrencies are targeted to have their own derivatives.
There are currently multiple derivatives available to trade on the cryptocurrency market. Each has its own advantages compared to simply trading the spot price.
Simply put, futures are contracts to buy or sell a certain product in the future at a specified price. A lot of future traders do not actually wish to own the underlying asset and therefore close their position before expiration. While futures usually have an expiration date, there are a lot of perpetual futures available when it comes to trading cryptocurrencies.
Futures allow for the possibility to leverage your capital as exchanges currently offer up to 125x leverage for their future contracts. The exact leverage differs per exchange and product. Futures used for both speculation as well as hedging since short positions are possible.
The derivative product in the cryptocurrency market with the highest trading volume is the perpetual swap. This product acts like a future without any expiration date. However, a feature that is unique to the perpetual swap is the funding rate. When the price of the perpetual swap moves above the spot price, those that are long must pay the funding rate to those with short positions. The opposite is true when the spot price is less than the price of the perpetual swap. In this way, the holders of the perpetual swaps are incentivized to close their positions when the price is too far from the spot price and they are supposed to pay for holding their positions. By closing their positions, they push the price of the perpetual swap towards the spot price.
The use of the term “perpetual swap” in the cryptocurrency market is technically incorrect. A traditional swap is a series of forward contracts, which are agreements in advance to make a trade at a certain date at a certain price. The only time money is exchanged is at the expiration of the contract.
Traditionally speaking, transactions of swaps are OTC transactions that are not subject to direct regulation, whereas futures are traded on the exchange. On cryptocurrency markets, the perpetual swaps are openly traded on exchanges.
CFD’s, or Contracts for Difference, are similar to futures although futures are usually traded on exchanges between traders whereas CFDs are often directly traded with brokers. With CFDs, it is also never meant for the ownership of the underlying asset to change hands but strictly to speculate on price movements. Just as with futures, CFDs can be used to both speculate as well as hedge by short selling.
There are both call and put options. Call options give the holder the right to buy the underlying asset at a specified price, known as the strike, and have an expiration date at which this is possible. The same goes for put options. Only here, the holder has the right to sell the underlying asset at the strike at the expiration date.
Writing options is also a possibility. When you write a call option, you have the obligation to sell the underlying asset at the strike at expiration. When writing a put option, you will be obligated to buy the underlying asset at the strike
The possible trading strategies with options seem endless due to the many ways options with different strike prices and expiration dates can be combined. They can be used both to directly speculate or simply lower risk of an investment in the underlying asset.
ETP’s, or Exchange-Traded Product, are products on the traditional stock markets that are backed by other asset(s). During the second half of 2018 the first ETP was launched in Switzerland, the Amun Crypto Basket Index ETP. The assets that this ETP represented, were the five largest cryptocurrencies by market cap at the time of launch. Last year, another ETP was launched in Switzerland. This time it was fully backed by Bitcoin.
The ETP is not used to hedge existing positions in cryptocurrencies but merely to gain exposure through the stock market in this case.