Bitcoin and cryptocurrency are an entirely new financial product for the world. It is not always that a new financial instrument comes along. The uniq
Bitcoin and cryptocurrency are an entirely new financial product for the world. It is not always that a new financial instrument comes along. The unique thing about bitcoin is that it is still a nascent industry. As such, there is a potential to earn huge amounts of profit. History stands proof to the fact that a new breakthrough industry can create a new generation of wealthy people. Which is why Bitcoin derivatives has become so popular recently.
Although the hardcore bitcoin proponents would like to get involved with bitcoin directly, many mainstream investors choose derivatives. Derivatives are common in the legacy markets. In Bitcoin, however, they are still quite new.
What Is A Derivative?
A derivative is a financial contract between two parties that derives its value from an underlying asset. Hence the name “derivative”. Some of the most common underlying assets are stocks, bonds, commodities, and currencies. However, they can be used for most assets. Bitcoin is definitely one of them.
The derivative is one of the oldest forms of a financial contract. In modern times, they are considered as contracts between buyers and sellers. These participants want to buy or sell a particular asset at a definite price in the future.
Derivatives play their own useful roles in financial markets. However, they have some downsides as well. Regardless, they are one of the most popular financial products in the world today.
What Are The Different Forms of Derivatives?
There are basically four different forms of derivatives. Investors can choose any of these as per their unique needs or even play with more than one. The four forms are as follows:
Options are financial instruments that give the buyer the right to buy or sell the underlying asset. They need to exercise this right by the specific expiration date. In this case, the buyer is not obligated to buy or sell if they choose not to.
Futures are derivative contracts that have an element of obligation to them. The buyers and sellers are required to transact the underlying asset at a predetermined future price and date.
Swaps are financial instruments that are used by the parties to exchange one type of cash flow for another. The most common kind of swap is an interest rate swap.
Forwards are derivative contracts that are similar to futures. However, these can be customized to fit the needs of the parties involved.
Why Use A Derivative?
If you haven’t heard about derivates before, you might ask about the utility of derivatives. Why would you want to trade in contracts when you can trade in the underlying asset directly? Well, there are many reasons why. After all, they wouldn’t have survived for hundreds of years if they didn’t have a purpose.
Derivates are usually used for hedging by seasoned investors and traders. This means to profit from an asset to offset any losses made from another asset. This helps investors protect themselves from market fluctuations. Traders use the same strategy while trading cryptocurrencies as well. Since crypto markets are highly volatile in nature, derivatives become even more useful.
When it comes to Bitcoin, derivatives act pretty much the same. Buyers and sellers sign contracts to transact in a specific crypto for a set price in the future. The contract reflects the change in prices of the Bitcoin. Traders use cryptocurrency exchanges or over the counter platforms to trade Bitcoin derivatives.
The high volatility of Bitcoin makes it very attractive for investors to use Bitcoin derivatives. Traders can buy contracts for an asset that is low in volume and sell them later at a high price. They can also short an asset if they believe it its price is going to fall. In both cases, they stand to profit.
The first-ever bitcoin derivative, a futures contract, was launched by CBOE and CME in the US in December 2017. CBOE stands for Chicago Board Options Exchange and CME stands for Chicago Mercantile Exchange. Since then many Bitcoin derivative products have surfaced and become popular.
Advantages of Derivatives
There are many prominent advantages of derivatives. It is an important financial instrument for seasoned traders and investors. The following are the main benefits:
As mentioned above, derivatives are popularly used as hedging tools. Investors use derivatives to protect their overall investment portfolio. They are used to offset the risk of losses from another trade. This is what some of the most disciplined traders and investors do.
Speculation remains the most popular use case for bitcoin and cryptocurrency. Traders want to profit off of the price movements of a Bitcoin. Since the industry as a whole is very volatile, they can make some handsome gains.
3. Protection From Certain Risks
The Bitcoin and cryptocurrency industry is still new. The various technologies associated with it are still being developed. As of now, owning and storing bitcoin still have an element of risk. The same goes for gold and cash too. Trading in derivatives does away with that risk. That’s because, in derivatives, you don’t actually own the underlying asset.
Disadvantages of Derivatives
There are quite a few disadvantages of derivatives as well. If you want to get involved with derivatives, you should definitely have them in mind.
1. Lack of Regulations
There is still a lack of clear regulations in the bitcoin derivatives market. As such, investors and traders face unprecedented risks. They are not protected in any manner. Yet, as of late, countries have been regulating cryptocurrency exchanges.
2. Bitcoin Volatility
Bitcoin has high volatility. Therefore, the derivatives based on them can present risks as well. Prices can skyrocket and plummet within minutes. This can cause traders to lose out on their investments.
3. New Avenue
Bitcoin derivatives are still new to the scene. As such, traders (especially retail traders) are not accustomed to them. If they do not understand the ins and outs of derivatives trading, they stand to lose. There is still a lot of customer education that is required in this field.