What are Cryptocurrency Derivatives and How to Use Them to Earn Income

A derivative is a financial contract whose predetermined value is based on interest rates. Each derivative has an underlying asset that determines risk and basic term structure. Those who trade with derivatives can mitigate risks (hedging) and improve returns; the traders’ main purpose is to increase the chance of cashing in on price fluctuations of standard and crypto-exchanges.

On the derivatives market, traders regard the stock value fluctuations as their main source of profit. Since no one can predict what the future base price of an asset will be, absolutely all trading participants risk it. At the time the contract obligations come into existence provided that the product got cheaper, the profits go to the seller and the risk of loss is on the buyer. In case the product rises in price, the buyer profits from it.

For example, if trader A expects BTC to drop to $3,000 by next Wednesday, he has the right to sign an agreement with trader B, and sell him coins once the price drops to $3,500. In this case, derivatives help reduce the risk. And if trader B wants to buy Bitcoin for $3,500 before Wednesday, he buys the contract from trader A. The sales and purchase agreement allows traders to make a profit regardless of the underlying assets’ worth. Therefore, derivatives are used as a good method of generating income.

Characteristics of Derivatives

Consider the case of an American businessman who holds an asset in USD, but wants to invest in a foreign country. Thus, the company’s income and costs are in different currencies. To resolve the problem, the company needs to find a transacting agent who is willing to swap “revenue streams”. For example, the investor can look for a business that sells its products in the US. It is important to note that both parties must have different expectations regarding the exchange rate movements.

To increase their income, traders use leverage, a loan provided by an exchange. The size of the leverage is proportional to the deposit made by the trader. As a result, traders get an opportunity to make profitable deals. The maximum leverage size is set by an exchange, and very often commission is provided.

Derivatives in Crypto

There are several types of cryptocurrency derivatives:

· Swaps. The derivative enables two parties to exchange a series of cash flows in the future, using an underlying asset.

· Futures. This contract obliges the traders to sell or buy an asset at a fixed price and a predetermined future price.

· Forwards

· Options allow the buyer to purchase an asset and the seller to sell an asset at a specified strike price. 

Swaps

The theory is that one party can avoid the risks inherent in a constant change of exchange rate by offering a floating interest rate. The gain one party receives through the swap will be equal to the loss of the other party. Hence, one of the businesses should acknowledge their potential exposure to losses in the operation.

Futures

Futures serve an important role in preventing an investor from losses from unfavourable price fluctuations. These derivatives allow to use leverage for trade speculations and to recognise possible pitfalls. There are two types of investors that benefit from futures: hedgers and speculators. Hedgers lock in the prices of their underlying assets to reduce the amount of risk associated with the security’s price change, whereas speculators try to make a profit from a security’s price change. 

Forwards 

Forwards are similar to futures, with an exception for the trading process. This type of derivative can be adjusted by the price and the date of enforcement. Forwards do not trade on centralized exchanges; instead, they integrate over-the-counter instrument (OTC). However, this involves greater risks of losing money.

Options 

An options contract is similar to the above derivatives, with an exception for its fixed value, referred to as the strike price. There are two types of contract: call options and pull options. Call options grants the investor the right to buy a share, whereas put options allows to sell it. Put holders have the right to sell their share on its effective date. On the contrary, option holders are obliged to trade their side if the other party executes the option and vice versa. Options contracts are used for both hedging and speculation strategies. 

Summary

Derivatives are new advancement in contemporary exchange market; Their value is based on an agreed underlying asset. Indeed, these financial contracts benefit many traders with its main perks, such as hedging risk exposure and asset price predetermination. 

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